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ECONOMICS 
FOR  THE  ACCOUNTANT 


ECONOMICS 
FOR  THE  ACCOUNTANT 


BY 

KEMPER  SIMPSON,  Ph.D. 

FORMERLY   LECTURER  IN   THE  JOHNS   HOPKINS   UNIVERSITY 
AND  ECONOMIST  IN  THE  FEDERAL  TRADE  COMMISSION 


D.  APPLETON  AND  COMPANY 

NEW  YORK  LONDON 

1921 


COPYRIGHT,    1921,   BY 

D.  APPLETON  &  COMPANY 


PRINTED  IN  THE  UNITED  STATES  OV  AUEBICA 


HT> 


J     / 


\ 


PREFACE 


In  these  days  any  text-book  iii  the  social  sciences  or 

on  the  principles  of  business  needs   an  apology.     The 

student  with  equipment  Avho  has  the  time  and  opportunity 

^   to  attempt  to  contribute  to  his  science  should  hesitate 

before  burdening  the  press  with  another  text.    I  paused, 

^  therefore,  before  adding  another  text  on  the  subject  of 

^  economics,  but  after  much  deliberation  decided  that  there 

^  was  a  definite  need  for  a  specialized  analysis  of  economic 

theory  for  the  accountant. 

The  economist  and  the  accountant  deal  with  substan- 
^  tially  the  same  facts,  even  though  they  have  different  per- 
.  spectives  and  somewhat  different  purposes.    The  economist 
is  usually  a  dispassionate  philosopher  who  looks  on  man's 
^  economic  activities  for  the  purpose  of  studying  and  ex- 
!  plaining  them.     The  accountant  is  working  in  the  midst 
5  of  business  organization  and  is  gathering  and  classifying 
"p.  facts  for  his  employer.     If  he  would  do  his  work  intel- 
.j  ligently,  he  must  have  some  understanding  of  the  economic 
system  in  which  his  employer  is  functioning.    There  are 
many  problems  of  interest  to  the  economist  that  have  only 
an  indirect  relation  to  the  accountant's  work.    For  this 
reason  the  ordinary  text-books  on  economic  theory  include 
lengthy   discussions    on   many   phases    of   economics   in 
which  the  accountant  is  not  interested  and  give  insuffi- 
cient treatment  to  what  he  would  consider  more  funda- 
mental problems.    It  might  be  supposed  that  some  of  the 
more  "practical"  economic  texts,  such  as  are  used  in  the 
business  schools,  might  give  the  accountant  what  he  needs. 
These  so-called  practical  texts,  however,  usually  collect 


vi  PREFACE 

and  schematize  certain  useful  facts  that  are  mere  com- 
monplaces to  the  practical  accountant.  Moreover,  it  will 
soon  be  discovered  that  it  is  the  most  abstract  and  subtle 
economic  reasoning  that  underlies  the  principles  of  ac- 
counting. 

When  this  work  was  first  being  planned,  it  was  sug- 
gested to  me  that  there  is  need  of  an  exposition  of  ac- 
counting for  the  economist.  This  book  should  also  be 
of  use  to  the  economist  who  is  interested  in  the  theory 
of  accounting.  Moreover,  any  economist  who  gives  con- 
sistent thought  to  accounting  will  find  much  of  purely 
theoretical  economic  interest  in  the  subject.  He  will  find 
that  he  must  be  more  careful  in  defining  capital,  interest, 
and  profit  and  that  he  will  have  to  make  some  important 
distinctions  between  the  different  kinds  of  cost.  I  feel 
that  through  my  contact  with  accounting  principles  I 
have  been  able  to  present  certain  more  or  less  important 
contributions  to  economic  theory. 

The  student  who  expects  to  get  the  most  out  of  this 
book  should  know  something  about  accounting,  and  if 
he  knows  anything  about  accounting,  he  will  necessarily 
have  some  grasp  of  the  fundamentals  of  economics.  In 
short,  this  book  was  not  written  primarily  for  the  ele- 
mentary accounting  student  although,  in  the  absence  of 
any  other  text  of  this  kind,  it  could  be  used  even  by 
students  of  elementary  accounting,  if  supplemented  by 
classroom  lectures. 

There  is  one  word  in  regard  to  the  scientific  method 
to  be  employed  in  the  two  studies,  and  especially  in 
accounting.  The  economist's  first  problem  is  to  determine 
"what  is";  a  description  of  "what  ought  to  be"  may 
follow,  but  it  should  be  predicated  on  a  knowledge  of 
"what  is."  The  economist  may  use  his  science  for  con- 
structing methods  of  improving  the  welfare  of  society. 


PREFACE  vii 

but  he  thereupon  becomes  a  reformer  or  even  a  propa- 
gandist. It  is  not  contended  here  that  an  economist 
should  not  at  times  be  a  reformer  or  a  propagandist,  but 
it  is  believed  that  he  should  be  careful  to  obtain  the  facts 
first.  The  accountant  probably  needs  more  warning  on 
this  score  than  the  economist.  The  accountant  may  work 
for  a  producer  or  for  a  public  body,  but  he  should  never 
change  his  definitions  or  adopt  a  revised  set  of  principles. 
The  concept  of  "cost"  should  never  be  changed  so  as  to 
serve  as  a  weapon  for  enforcing  good  financial  policy  or 
for  effecting  social  reform;  the  accountant's  definitions 
should  be  carefully  thought  out  and  rigorously  adhered 
to.  It  is  no  sound  arg-ument  against  the  principle  in- 
volved in  the  inclusion  of  interest  in  cost  that  the  applica- 
tion thereof  would  tend  to  inflate  cost  and  allow  the 
producers  greater  profits  than  they  would  otherwise  en- 
joy. The  amount  of  depreciation  the  accountant  should 
charge  should  not  be  affected  by  the  financial  condition 
of  the  company  or  by  the  wishes  of  its  directors.  The 
accountant  should  tell  the  truth  as  he  sees  it  and  should 
be  careful  not  to  revise  his  classifications  for  some  special 
purpose,  no  matter  how  justifiable  the  particular  cause 
may  seem  to  be. 

The  problem  of  interest  as  a  part  of  cost  is  so  much 
disputed,  and  the  light  that  economic  theory  can  throw 
on  the  discussion  is  so  considerable,  that  a  special  appendix 
is  devoted  to  the  subject.  The  problem  is  discussed  in 
Chapter  X  as  well  as  in  other  chapters,  but  an  entirely 
satisfactory  discussion  of  this  question  was  not  possible 
until  all  the  principles  outlined  in  Chapters  X  and  XI 
were  set  forth.  Before  this  problem  can  be  understood 
by  the  accountant,  he  must  establish  firmly  certain  careful 
definitions  of  the  entrepreneur,  the  capitalist,  capital, 
capital  goods,  cost,  interest,  and  profit.     Certain  other 


viii  PREFACE 

disputed  items,  which  might  have  been  discussed  ia 
Chapter  X,  were  reserved  for  Appendix  II  because  of 
their  technical  accounting  interest  and  because  it  was 
difficult  to  treat  them  until  all  the  general  principles  had 
been  set  forth. 

Kemper  Simpson 


CONTENTS 

PAGE 

Preface  v 

CHAPTER 

I.  EcoxoMics  AND  Accounting 1 

The  Development  of  Accounting 1 

The  Development  of  Economics 3 

The  Economist's  Point  of  View 4 

The  Accountant's  Point  of  View 5 

II.  The  Accountant's  Problems 8 

The  Balance  Sheet 8 

The  Profit  and  Loss  Account 12 

The  Cost  Statement 13 

III.  Consumption  and  Pkoduction 18 

The  Definition  of  Economies  and  Its  Subdivisions. .  18 

Production 19 

Labor 21 

Land 22 

Capital  Goods 23 

Capital 24 

The  Entrepreneur 26 

The  Division  of  Labor,  Distribution,  and  Exchange. .  31 

Another  Definition  of  Economics 32 

IV.  Distribution  34 

Distribution  and  Marketing 34 

The  Productivity  Theory  of  Distribution 36 

Wages 39 

Interest 43 

Profit 45 

V.  The  Economist's  Problem 47 

The  Meaning  of  Economics 47 


X  CONTENTS 

CHAPTER  PAGH 

The  Study  of  Prices 50 

Practical  Economics 51 

VI.  Price  and  Demand 54 

Price 54 

Marginal  Utility 56 

Marginal  Utility,  Cost,  and  Price 60 

Artificial  Stimulation  of  Demand 64 

VII.  Price  and  the  Medium  op  Exchange 54 

The  Marginal  Utility  of  Money 64 

The  Standard  of  Value  and  the  Medium  of  Exchange  66 

Paper  Money 68 

The  Quantity  Theory  of  Money 69 

Price  Indices 71 

The  Economic  Evils  of  Changing  Price  Levels 74 

VIII.  Economic  Cost  and  Accounting  Cost 77 

Economic  Costs 77 

Money  Costs 80 

Accounting  Costs  and  Entrepreneur's  Cost 81 

IX.  The  Elements  of  Accounting  Cost 86 

Raw  Materials 87 

Wages 91 

Overhead  92 

Joint  Costs 94 

X.  The  Doubtful  Elements'  of  Accounting  Cost 105 

Interest  in  Cost 106 

Rent  as  a  Cost  Item 108 

Depreciation  as  a  Cost  Item 110 

XI.  Capital,  Capital  Goods,,  and  Investment 113 

Uses  of  Capital 113 

The  Need  for  Determining  Capital 114 

The  Balance  Sheet 116 


CONTENTS  XI 

CHAPTER  P-A^GB 

The  Valuation  of  Capital  Goods 119 

Goodwill 124 

The  Basis  of  the  Interest  Charge 128 

XII.  Price,  Profit,  and  Cost 136 

Profit  and  Entrepreneur 136 

The  Pure  Entrepreneur 137 

Functions  of  the  Entrepreneur 139 

The  Risk  Theory  of  Profit 140 

The  Reason  for  Profit 142 

Principal  Kinds  of  Profit 145 

The  Relation  between  Price  and  Cost 147 

XIII.  Competition  152 

The  Assumptions  of  Competition 152 

Collective  Bargaining 154 

Price  Control 155 

Large  Scale  Production 157 

Unfair  Competition  and  the  Anti-Trust  Legislation. .  161 

XIV.  Taxation   165 

Man's  Political  Relations 165 

The  Purposes  of  Taxation 166 

The  Single  Tax 167 

The  Shifting  and  Incidence  of  Taxation 169 

The  Income  and  Profit  Taxes 170 


APPENDICES 

I.  Interest  as  a  Part  of  Cost 177 

II.  Cash   Discounts   on    Sales,   Bad   Debts,   Outward 

Freight,  Donations,  and  Taxes  on  Profits 190 

III.  Questions  in  Economics  for  C.  P.  A.  Examinations  198 
Index  203 


ECONOMICS 
FOR  THE  ACCOUNTANT 

CHAPTER   I 

ECONOMICS  AND  ACCOUNTING 

The  Development  of  Accounting. — Since  the  Civil 
War  business  organization  has  become  increasingly 
complex.  Business  units  have  become  larger  and  are 
not  so  readily  interpreted  by  simple  methods  of  book- 
keeping. Although  new  fields  of  industry  are  con- 
stantly being  invaded,  competition  in  many  lines  is 
becoming  keener  and  keener.  The  complexity  of 
business  organization  has  been  responsible  for  the 
replacement  of  the  bookkeeper  by  the  modern 
auditor,  and  the  keenness  of  competition,  along  with 
other  factors,  has  developed  the  field  of  the  cost 
accountant.^  The  World  War  too,  through  the  neces- 
sity of  price  fixing  and  taxation  (especially  the 
income  and  excess  profits  taxes),  has  made  it  neces- 
sary for  all  business  to  give  some  consideration  to 
the  problems  of  accounting. 

Although  modern  accounting  has  developed  from 
bookkeeping,  the  modern  accountant  must  have  a 

*  The  cost  accountant  establishes  the  price  below  which  it  would  be 
unprofitable  to  sell. 

1 


2    ECONOMICS  FOR  THE  ACCOUNTANT 

much  larger  equipment  than  the  old-fashioned  book- 
keeper. As  business  organizations  have  grown  larger 
and  more  complex,  the  producer  has  been  less  able 
to  grasp  all  the  facts  of  his  business  and  has  come 
to  depend  upon  the  accountant  more  and  more  for 
a  summarization  of  details.  Furthermore,  the  ac- 
countant has  developed  from  a  mere  keeper  of 
records  (that  is,  a  bookkeeper)  into  an  interpreter 
of  those  records.  The  producer  relies  on  his  ac- 
countants for  all  those  facts  that  he  needs  in  deter- 
mining his  business  policies.  But  it  must  be  remem- 
bered that  the  producer  is  not  working  alone;  he  is 
functioning  in  a  complex  economic  organization,  and 
it  is  the  accountant's  business  to  understand  the 
economic  relations  of  his  employer.  If  the  ac- 
countants do  not  understand  the  system  in  which  the 
producer  functions,  of  what  use  to  him  will  their 
presentation  of  facts  be?  In  short,  accounting  is 
merely  a  combination  of  scientific  bookkeeping  and 
economics.^ 

In  order  to  comprehend  the  differences  between 
the  functions  and  the  purposes  of  the  accountant  and 
the  economist,  it  will  be  necessary  to  consider  the 
way  in  which  accountancy  and  economics  first  at- 
tracted the  attention  of  mankind.  As  early  as  there 
was  business  there  was  some  kind  of  bookkeeping, 
but  it  was  not  until  business  became  complex  that 
the  principles  of  accounting  were  formulated  and  it 
was  not  until  competition  became  keen  that  cost  ac- 
counting and  auditing  (as  it  is  understood  to-day) 

'Economics  includes  corporation  finance,  taxation,  etc.,  as  well  as 
pure  economic  theory. 


ECONOMICS  AND  ACCOUNTING      3 

began  to  claim  so  much  attention.  Accounting,  then, 
has  become  a  science  since  the  '80s. 

The  Development  of  Economics. — Economics,  or 
political  economy,  has  had  a  respectable  position 
among  the  sciences  ever  since  the  Kevolutionary 
War  and  its  principles  have  been  more  or  less  heeded 
by  governments  since  the  Napoleonic  Wars.  Political 
economy  descended  from  two  very  unlike  parents; 
the  finance  minister  of  kings  and  the  academic 
philosopher.  The  problems  of  taxation  and  money 
early  interested  the  monarchs  of  Europe  and  their 
ministers  of  finance.  The  kings  of  France  thought 
of  the  people  merely  as  taxpayers  who  supplied  them 
with  the  means  for  lavish  expenditures,  but  Quesnay 
warned  them  that  a  rich  people  make  a  rich  country 
and  a  rich  king.  The  other  parent  of  political 
economy  was  the  professor  of  philosophy,  who 
stopped  to  consider  man  in  his  economic  as  well  as 
his  ethical  and  political  relations.  Francis  Hutche- 
son  and  Adam  Smith  gave  political  economy  an 
academic  position,  which  stimulated  the  keenest 
scientific  minds  to  give  it  attention. 

Adam  Smith's  book  was  called  the  Wealth  of 
Nations,  but  would  probably  have  been  called 
Political  Economy  had  not  another  book  by  Sir 
James  Stewart  with  that  title  appeared  a  few  years 
before.  To-day,  * '  economics ' '  is  probably  more  com- 
mon than  ''political  economy,"  but  the  older  term  is 
significant  in  that  it  shows  that  it  was  the  effect  of 
the  state  on  the  economic  relations  of  man  and  on 
the  wealth  of  nations  that  was  of  particular  interest 
to  the  economist.    Economics  in  England  and  in  the 


4    ECONOMICS  FOR  THE  ACCOUNTANT 

United  States,  to-day,  lays  less  stress  than  formerly 
on  the  state  and  more  on  the  consumers  and  laborers 
as  classes.  It  is  a  fact  of  some  interest  that  just 
before  the  War  a  German  economist  of  distinction 
remarked  that  there  were  very  few  American  econo- 
mists who  gave  sufficient  attention  to  the  state  in 
their  studies,  and  that  there  were  few  American 
political  economists  for  that  reason.  It  was  char- 
acteristic of  German  economics  and  of  German  gov- 
ernment that  the  importance  of  the  state  was  always 
emphasized.  In  England  and  the  United  States,  a 
policy  of  laissez-faire  allowed  men  to  develop 
economic  organizations  with  the  least  possible  gov- 
ernmental interference.  The  protectionism,  govern- 
ment ownership,  and  taxation  of  Germany  were 
consistent  with  German  political  economy,  whereas 
English  free  trade,  private  ownership,  and  taxation 
cannot  be  dissociated  from  English  economics.^ 

The  Economist's  Point  of  View.— Although  the 
economists  of  to-day  may  be  less  interested  in  the 
state  than  were  the  early  political  economists,  they 
have  always  retained  their  interest  in  society.  It  is 
society  as  consumer  and  society  as  producer  that  the 
economist  considers.  No  individual  or  no  one  group 
of  individuals  should  occupy  the  economist's  entire 
attention  or  receive  special  treatment.  He  may  work 
for  one  or  the  other  of  these  groups,  for  example, 
laborers,  entrepreneurs,  etc.,*  but,  then,  he  becomes 

'Protectionism  in  the  United  States  is  explained  by  the  necessity 
of  helping  certain  industries  to  get  on  their  feet,  whereas  German 
protectionism  was  a  governmental  policy  designed  to  make  Germany 
a  Belf-sufficing  political  unit. 

*  See  Chapter  III,  page  26. 


ECONOMICS  AND  ACCOUNTING  5 

a  propagandist  and  is  in  danger  of  losing  his  impar- 
tial scientific  attitude.  The  economist  describes  and 
attempts  to  show  causal  relations,  but  he  should  be 
careful  whenever  he  introduces  ethics  and  talks  of 
what  "ought  to  be"  rather  than  of  what  "is."  It 
is,  to  say  the  least,  practical  to  determine  what  "is" 
before  deciding  what  "ought  be  be." 

The  Accountant's  Point  of  View. — The  accountant 
is  the  producer's  (entrepreneur's)  bookkeeper, 
grown  philosopher.^  Even  the  public  accountant 
does  most  of  his  work  for  the  entrepreneur.  He 
analyzes  the  activities  of  the  producer's  business,  and 
only  incidentally  considers  those  of  society  as  a 
whole.  While  he  sets  up  his  accounts,  he  always  has 
in  mind  that  they  are  being  prepared  for  his  em- 
ployer: he  is  concerned  with  the  laborers  merely  be- 
cause they  receive  wages,  which  he  must  include  in 
his  employer's  costs  or  expenses.  The  consumers, 
for  whom  it  will  be  shown  all  production  is  carried 
on,  claim  the  accountant's  attention  only  because 
they  pay  the  producer  prices,  which  constitute  the 
"Sales"  of  the  accountant's  Profit  and  Loss  State- 
ment. The  accountant  in  rare  circumstances  may  be 
called  upon  to  make  "special  examinations"  for  the 
benefit  of  consumers,  as  in  a  public-utility  case.  The 
accountant,  then,  usually  studies  the  individual  busi- 
ness, whereas  the  economist  studies  all  businesses 
and  their  inter-relations. 

It  has  often  been  pointed  out  that  accounting  is 
merely  a  science  of  classification,  analogous  to 
anatomy.    Economics  not  only  describes  and  classi- 

"See  Chapter  III. 


6    ECONOMICS  FOR  THE  ACCOUNTANT 

fies  but  attempts  to  give  ultimate  explanations.  A 
scientific  explanation,  however,  is,  in  one  sense, 
merely  a  description  of  cause  and  effect.  It  may 
be  that  the  economist  should  have  worked  out  the 
principles  on  which  accounting  classifications  should 
be  based,  but  economists  have  been  so  busy  studying 
society  and  businesses  collectively  that  they  have 
neglected  to  consider  the  science  of  business  from 
the  individual  producer's  point  of  view.  So  the 
accountant  has  had  to  work  out  principles  and  set 
up  theories  behind  his  classifications,  because  all 
serviceable  classifications  are  built  on  principles  and 
even  theories.  But  inasmuch  as  the  two  professions 
are  dealing  with  the  same  phenomena,  and  since  both 
the  accountants  and  the  economists  are  primarily 
describing  facts,  their  points  of  view  may  be  differ- 
ent, but,  in  the  last  analysis,  they  should  be  recon- 
cilable. 

Even  though  the  accountant  works  for  some  par- 
ticular producer,  that  producer  functions  in  a 
complicated  economic  system,  about  which  the 
accountant  must  have  some  knowledge.  The  pro- 
ducer has  contacts  with  the  market,  in  which  there 
are  other  producers  and  consumers;  he  also  has 
contacts  with  capitalists  and  with  laborers.  The 
accountant  must  know  something  of  the  intricate 
system  in  which  his  employer  functions.  He  cannot 
build  a  wall  around  the  business  for  which  he  is 
making  classifications;  he  cannot  tell  his  employer 
*'so  much  you  must  add  to  cost  before  arriving  at 
selling  price"  and  *'in  this  way  you  should  value 
your  assets"  if  the  market  refuses  to  consider  the 


ECONOMICS  AND  ACCOUNTING  7 

employer's  or  the  accoimtant 's  ideas  and  desires  in 
the  matter.  That  accountant  is  most  successful  who 
is  aware  of  the  place  of  his  house  in  the  greater 
economic  organization.  It  will  be  shown,  for  ex- 
ample, that  his  house  seeks  through  price  to  get 
income  from  the  larger  economy  and  that  it  draws 
upon  that  economy  for  the  goods  and  services  for 
which  it  meets  costs;  the  difference  is  profit. 
Strangely  enough,  however,  costs  are  not  always  so 
easily  defined  as  they  might  seem  to  be;  as  a  result, 
with  the  varying  definitions  of  costs,  there  are  vary- 
ing definitions  of  profit.  The  accountant's  definition 
of  cost  is  not  always  identical  with  that  of  the 
economist,  and  likewise  their  definitions  of  profit  will 
differ.  It  is  evident  that  some  reconciliation  is  neces- 
sary, but  a  rather  careful  scrutiny  of  both  economic 
and  accounting  categories  must  precede  the  state- 
ment of  this  reconciliation.  Moreover,  the  economist 
does  well  to  consider  the  accountant's  problems  and 
findings.  The  accountant  is  working  at  the  heart 
of  economic  realities  and  he  sees  facts  and  truths 
that  the  economist  may  be  too  much  in  the  clouds  to 
recognize.  Too  many  economists  maintain  their  per- 
spective at  such  a  height  that  they  fail  to  see  the 
homely  truths  that  are  apparent  to  the  burrowing 
accountant.  This  book  attempts  to  establish  between 
them  contacts  that  should  be  mutually  beneficial. 


CHAPTER  II 

THE  accountant's  PROBLEMS 

The  accountant  must  be  able  to  obtain  from  tbe 
records  of  a  company  data  that  will  answer  three 
principal  questions:  (1)  What  were  the  sales  or  in- 
come and  the  expenses  or  outgo  of  the  business  in 
any  particular  period?  (2)  What  were  the  specific 
costs  of  the  different  products  handled  or  produced? 
and  (3)  How  much  capital  was  invested  in  the  busi- 
ness and  how  can  the  present  worth  of  the  business 
be  estimated?  The  Profit  and  Loss  account,  the  Cost 
Statement,  and  the  Balance  Sheet  are  constructed  by 
the  accountant  in  order  to  answer  these  questions. 
These  three  statements  can  be  used  to  answer  ques- 
tions other  than  those  suggested  and  some  of  the 
additional  questions,  which  are  significant,  will  be 
treated  in  other  places  in  this  book. 

The  Balance  Sheet. — The  Balance  Sheet  is  sup- 
posed by  many  accountants  to  give  merely  an  ac- 
curate financial  picture  of  the  business  at  a  particular 
time,  but  this  belief  is  due  to  a  misconception  of  the 
possibilities  of  determining  such  an  accurate  state- 
ment. It  will  be  shown  that  the  Balance  Sheet 
should  contain  the  original  cost  of  the  assets  not 
their  market  valuation;  but  it  is  a  question  whether 
a  statement  of  this  kind  could  be  used  to  give  the 
stockholders  or  the  creditors  any  idea  of  the  market 

8 


THE   ACCOUNTANT'S  PROBLEMS  9 

value  of  the  assets  at  the  time  the  Balance  Sheet  is 
being  used.    (See  Chapter  XI.) 

For  whom  is  the  Balance  Sheet  made  ?  Obviously 
for  those  who  own  the  business.  To  the  common 
stockholders  (or,  as  will  be  shown  later,  the  entre- 
preneur), who  own  the  business,  the  accountant  is 
responsible;  his  statements  are  made  for  them.  On 
the  one  side  (according  to  American  custom,  the  left 
side),  the  different  assets  are  enumerated  and  some 
monetary  evaluation  is  set  beside  each;  legally  these 
assets  belong  to  the  common  stockholders.  On  the 
right  side,  the  stockholders '  obligations  to  the  banks 
and  to  the  bondliolders  (or  other  creditors)  are  first 
shown  and  underneath  these  liabilities  are  included 
the  Common  Stock  and  Surplus,  which  represents 
the  excess  of  assets  over  liabilities,  and  which  belong 
to  the  common  stockholders.  The  form  of  Balance 
Sheet  recommended  for  the  use  of  manufacturers  by 
the  Federal  Reserve  Board  is  presented  on  pages  10 
and  11. 

This  Balance  Sheet  is  supposed  to  serve  a  number 
of  purposes.  First,  it  should  give  the  accountant  a 
record  of  the  amount  of  capital  invested  in  the  busi- 
ness; as  a  basis  for  an  interest  charge  or  for  measur- 
ing the  return  earned,  the  amount  of  capital  invested 
represents  a  very  important  figure.  The  Balance 
Sheet  will  give  the  amount  of  capital  invested,  if 
assets  are  shown  at  original  cost.  Second,  it  is  com- 
monly used  by  the  stockholders,  directors,  and  man- 
agers to  obtain  an  estimate  of  the  financial  condition 
of  their  business  at  any  time.  Third,  it  furnishes 
them  with  a  statement  for  the  hank  from  which 


10        ECONOMICS  FOR  THE  ACCOUNTANT 


Form  of  Balance  Sheet  Recommended 

A88ET8 


Cash: 

la.  Cash  on  hand — currency  and  coin 

lb.   Cash  in  bank 

Notes  and  accounts  receivable: 

3.  Notes   receivable  of  customers  on  hand   (not 

past  due) _. . 

5.  Notes  receivable  discounted  or  sold  with  in- 
dorsement or  guaranty 

7.  Accounts  receivable,  customers  (not  past  due) . 
9.  Notes   receivable,    customers,    past   due   (cash 

value,  $) 

11.  Accounts  receivable,  customers,  past  due  (cash 

value  $,....) 

Less: 

13.  Provisions  for  bad  debts 

15.  Provisions       for       discounts, 

freights,  allowances,  etc 


Inventories: 

17.  Raw  material  on  hand 

19.   Goods  in  process 

21.   Uncompleted  contracts 

Less  payments  on  account  thereof. 

23.  Finished  goods  on  hand 

Other  quick  assets  (describe  fully): 


Total  quick  assets  (excluding  all  investments) . 


Securities: 

25.  Securities  readily  marketable  and  salable  with- 
out impairing  the  business 

27.  Notes  given  by  officers,  stockholders,  or 
employees 

29.  Accounts  due  from  officers,  stockholders,  or 
employees 


Total  current  assets 

Fixed  assets: 

31.  Land  used  for  plant 

33.   Buildings  used  for  plant 

35.   Machinery 

37.  Tools  and  plant  equipment 

39.   Patterns  and  drawings 

41.   Office  furniture  and  fixtures 

43.  Other  fixed  assets,  if  any  (describe  fully) . 


Less: 

45.  Reserves  for  depreciation. 


Total  fixed  assets. 


Deferred  charges: 

47.  Prepaid  expenses,  interest,  insurance,  taxes,  etc. 
Other  assets  (49) 

Total  assets 


THE  ACCOUNTANT'S  PROBLEMS 


11 


BY  THE  Federal  Reserve  Board 

LIABILITIES 

Bills,  notes,  and  accounts  payable: 
Unsecured  bills  and  notes: 

2.  Acceptances  made  for  merchandise  or  raw 

material  purchased 

4.  Notes     given     for     merchandise     or     raw 

material  purchased 

6.   Notes  given  to  banks  for  money  borrowed. . 

8.   Notes  sold  through  brokers 

10.   Notes   given   for   machinery,   additions   to 

plant,  etc 

12.  Notes  due  to  stockholders,  officers,  or 
employees 

Unsecured  accounts: 

14.  Accounts   payable   for  purchase   (not  yet 

due) 

16.  Accounts  payable  for  purchases  (past  due). 
18.  Accounts  payable  to  stockholders,  officers, 

or  employees 

Secured  liabilities: 

20a.  Notes  receivable  discounted  or  sold  with 
indorsement  or  guaranty  (contra) 

206.  Customers'  accounts  discounted  or 
assigned  (contra) 

20c.  Obligations  secured  by  liens  on  in- 
ventories   

20d.  Obligations  secured  by  securities  de- 
posited as  collateral 

22.  Accrued  liabilities  (interest,  taxes,  wages, 

etc.) 

Other  current  liabilities  (describe  fully) : 


Total  current  liabilities 

Fixed  liabilities: 

24.   Mortgage  on  plant  (due  date ) 

26.   Mortgage  on  other  real  estate  (due  date ) 

28.   Chattel  mortgage  on  machinery  or  equipment 

(due  date ) 

30.  Bonded  debt  (due  date ) 

32.  Other  fixed  liabilities  (describe  fully) : 


Total  liabilities , 

Net  worth : 

34.  If  a  corporation: 

(o)  Preferred  stock  (less  stock  in  treasury^ 
(fc)  Common  stock  (less  stock  in  treasury) 
(c)    Surplus  and  undivided  profits 


Less: 


(d)  Book  value  of  good  will . 

(e)  Deficit 


36.  If  an  individual  or  partnership: 

(a)   Capital 

(6)    Undistributed  profits  or  deficit. 

Total 


12   ECONOMICS  FOR  THE  ACCOUNTANT 

they  may  desire  to  secure  credit.  This  third  purpose 
explains  the  arrangement  of  the  assets:  the  fluid  as- 
sets, those  that  can  be  easily  liquidated  in  case  of 
emergency,  are  shown  first.  Probably  the  greatest 
theoretical  difficulty  presented  by  the  Balance  Sheet 
is  the  principle  of  evaluation  of  the  assets.  Should 
they  always  be  valued  at  their  original  cost,  or 
should  they  be  revalued  with  an  increase  in  their 
market  value  due  to  an  outside  demand,  increased 
quantity  of  money,  or  greater  productivity?  These 
questions,  which  are  really  economic  rather  than  ac- 
counting questions,  can  only  be  answered  by  ac- 
countants who  have  a  clear  understanding  of  the 
meaning  of  economic  categories.  (See  Chapter 
XI). 

The  Profit  and  Loss  Account. — If  the  accountant 
needed  to  find  the  profit  or  loss  of  the  stockholders 
realized  in  a  period,  it  might  be  supposed  that  he 
could  compare  the  Balance  Sheet  for  the  beginning 
of  the  period  with  the  Balance  Sheet  for  the  end  of 
the  period.^  There  are  certain  practical  difficulties 
involved  in  arriving  at  profit  in  this  way:  as  a 
matter  of  fact,  the  second  Balance  Sheet  is  ordi- 
narily derived  from  the  first  after  the  profit  during 
the  period  has  been  determined  and  added  to  the 
surplus.  Unless  assets  are  revalued,  and  it  will  be 
shown  that  this  would  be  bad  accounting,  the  two 
Balance  Sheets  would  only  differ  by  the  amount  of 
the  profit  or  loss.  Furthermore,  even  if  revaluation 
were  allowed,  the  accountant  would  find  it  necessary 

*  This  profit  would  not  be  pure  economic  profit  but  a  combination  of 
profit  and  interest  on  the  capital  invested  by  the  stockholders. 


THE  ACCOUNTANT'S  PROBLEMS 


13 


Profit  and  Loss  Account  Recommended  by  the  Federal 
Reserve  Boaed 

Comparative  statement  of  profit  and  loss  for  three  years  ending 19. 


Year  ending  — 

19— 

19— 

19— 

% 

% 

S 

Net  sales 

Inventory  beginning  of  year 

Loss  inventory  end  of  year 

Cost  of  sales 

Selling  expenses  (itemized  to  correspond  with 
ledger  accounts  kept) 

Total  selling  expense. 

General  expenses  (itemized  to  correspond  with 
ledger  accounts  kept) 

Total  general  expense 

Administrative    expenses    (itemized    to    cor- 
respond with  ledger  accounts  kept) .  . 

Total  expenses 



Net  profit  on  sales 

Other  income: 

Income  from  investments 

Interest  on  notes  receivable,  etc 

Gross  income 

Deductions  from  income: 

Interest  on  bonded  debt 

Interest  on  notes  payable 

Total  deductions 



Net  income — profit  and  loss 

Add  special  credits  to  profit  and  loss 

' 

Deduct  special  charges  to  profit  and  loss 

Profit  and  loss  for  period 

Surplus  beginning  of  period 

Dividends  paid 

Surplus  ending  of  period 

14   ECONOMICS  FOR  THE  ACCOUNTANT 

to  separate  profits  from  the  sales  of  products  pro- 
duced or  handled  from  gains  on  the  sale  of  assets. 
The  Profit  and  Loss  account  on  page  13  was  recom- 
mended by  the  Federal  Keserve  Board  in  the  same 
pamphlet  from  which  the  Balance  Sheet  on  pages 
10  and  11  was  taken.^ 

The  Profit  and  Loss  account  gives  a  financial  sum- 
mary of  the  transactions  of  a  business  throughout  a 
definite  period.  It  sets  forth  the  income  or  sales  and 
the  outgo  or  expenses  in  order  to  show  the  differ- 
ence, that  is,  the  profit  realized.  The  accountant's 
principal  difficulty  lies  in  determining  what  to  do 
with  the  producer's  or  stockholders',  that  is,  the 
entrepreneur's,  sacrifices,  which  are  not  represented 
by  actual  expenditures,  such  as  depreciation,  rent 
on  land  owned,  and  interest.  On  the  treatment  of 
these  much  disputed  items  in  accounting  economic 
theory  can  throw  much  light  (see  Chapter  X  and 
Appendix  I). 

The  Cost  Statement. — ^In  a  business  in  which  only 
one  product  of  one  grade  and  of  one  size  is  handled, 
there  is  no  need  for  any  separate  Cost  Statement 
provided  the  items  of  expense  are  analyzed  and  not 
thrown  together  in  one  lump  sum  such  as  is  done  on 
the  foregoing  Profit  and  Loss  account.  Although 
the  item  "Cost  of  Sales,"  as  shown,  represents  a 
summary  of  the  costs,  it  is  often  analyzed  on  the 
Profit  and  Loss  account.    For  a  manufacturing  busi- 

s  There  is  one  obvious  criticism  of  this  Profit  and  Loss  account, 
which  was  constructed  for  a  jobbing  rather  than  a  manufacturing 
business:  Cost  of  Sales  should  include  Selling  and  General  and  Ad- 
ministrative Expense.  The  item  "Cost  of  Sales"  should  have  been 
called  Cost  of  Goods  Sold. 


THE    ACCOUNTANT'S  PROBLEMS 


15 


ness  it  could  be  analyzed  about  as  indicated  in  the 
following  statement: 

Cost  Statement,  January  1-December  31 


Quantity  of  Product  Man 
ufactured  (pounds,  tons, 
or  cases,  etc.) 


{Add) 
Quantity  of  Product  on 
hand  January  1 


(Deduct) 
Quantity  of  Product  on 
hand  December  31 


Quantity  of  Product  Sold . 


Raw  Materials.  .  . 

Wages 

Factory  Overhead. 


Total  Factory 

(Add) 
Cost  of   Inventories   on 
hand  January  1 


Total 

(Deducl) 
Cost  of   Inventories   on 
hand  December  31 


Manufacturing  Cost  of 
Goods  Sold 

General  and  Administra- 
tive  

Selling 


Cost  of  Sales . 


From  this  statement  the  different  costs  per  unit 
of  product  can  be  obtained  by  dividing  the  quantity 
produced  into  the  various  production  costs  or  the 
quantity  sold  into  the  administrative  and  selling 
expenses  or  the  cost  of  sales.  Obviously  when  a 
number  of  different  products  of  different  sizes  and 
grades  are  produced  or  handled,  the  problems  of  cost 
accounting  become  more  difficult.  Even  if  a  careful 
record  is  kept  for  the  costs  of  the  raw  materials  go- 


16   ECONOMICS  FOR  THE  ACCOUNTANT 

ing  into  each  of  the  different  products  of  the  dif- 
ferent sizes  and  grades  manufactured,  there  are 
many  costs  that  are  not  so  easily  allocated.  It  will 
be  shown  in  Chapter  IX  that  even  with  careful 
records  the  allocation  of  the  raw-material  costs  for 
co-products  and  joint-products  may  present  a  very 
complicated  economic  problem.  The  allocation  of 
labor  costs  represents  another  difficulty,  particularly 
if  the  same  laborers  work  on  a  number  of  the  differ- 
ent products  or  on  the  different  sizes  and  grades  of 
the  same  products.  The  most  difficult  problem,  how- 
ever, is  presented  by  the  overhead.  A  reasonable 
allocation  of  light,  heat,  and  power,  of  rent,  or  of 
administrative  salaries  takes  much  of  the  accoun- 
tant's thought;  to  the  solution  of  this  problem,  the 
economist  can  add  but  little.  When  it  comes  to  the 
determination  of  what  items  should  be  included  in 
cost,  and  the  reasoning  pertinent  to  the  disputed 
items,  however,  the  economist  can  add  much. 

The  economist  is  interested  in  a  speedy  and  ac- 
curate solution  of  these  problems  of  the  accountant. 
Economically  desirable  differences  in  prices  for  the 
different  commodities  of  the  various  sizes  and  grades 
can  only  be  determined  after  accurate  costs  have 
been  established.  Furthermore,  economies  in  pro- 
duction can  be  best  effected  by  accurate  and  compre- 
hensive unit  costs.  The  economist  talks  much  of 
the  proper  or  most  economic  proportions  of  labor, 
capital  goods,  and  land  in  production.  He  insists 
that  one  of  the  principal  functions  of  management 
is  the  judicious  use  of  these  factors.  It  will  be  shown 
that  the  comparisons  of  the  itemized  unit  costs  of 


THE  ACCOUNTANT'S  PROBLEMS     17 

the  different  factories,  or  for  the  different  proc- 
esses, or  for  the  same  factory  or  process  for  dif- 
ferent months  or  years  enable  those  responsible  to 
effect  the  necessary  economies  in  production. 


CHAPTER  ni 

CONSUMPTION  AND  PRODUCTION 

The  Definition  of  Economics  and  Its  Subdivisions. 

— Economics  is  the  social  science  that  deals  with  man 
in  his  efforts  to  make  a  living  or  to  satisfy  his  wants. 
There  are  two  processes  involved;  one  is  concerned 
with  the  satisfaction  of  man's  wants;  the  other  is 
concerned  with  the  efforts  of  man  in  obtaining  those 
things  that  he  desires.  The  first  of  these  processes 
is  called  Consumption;  the  second  is  called  Produc- 
tion. In  the  simplest  type  of  economic  organization, 
Crusoe  desired  food,  clothes,  and  shelter  (this  is,  he 
desired  to  consume)  and  he,  therefore,  had  to  exert 
effort  (that  is,  produce)  in  order  to  satisfy  his 
wants.  Consumption  is  both  the  beginning  and  the 
end  of  economic  study:  it  furnishes  the  incentive  for 
economic  endeavor  and  it  constitutes  the  ultimate 
purpose  of  all  economic  organization.  It  is  seldom 
that  man  produces  merely  for  the  love  of  producing; 
he  produces,  or  lends  others  aid  in  production,  ordi- 
narily because  he  desires  to  consume  and  because 
under  no  other  condition  would  he  be  permitted  to 
do  so.  Economics  considers  every  human  being  a 
consumer,  whenever  he  has  a  desire  and  obtains 
(purchases)  satisfaction.  The  consumer  procures 
satisfaction,  although  what  he  apparently  purchases 
are  "goods  or  services."    A  **good"  is  a  physical, 

18 


CONSUMPTION  AND  PRODUCTION  19 

but  not  necessarily  a  tangible,  thing  tbat  gratifies 
the  consumer's  desire.  A  ''service"  is  the  result  of 
human  effort  that  takes  no  purely  physical  mani- 
festation. Consumption  might  seem  to  presuppose  a 
reduction  of  the  amount  of  matter  in  existence. 
AVhen  a  man  eats  a  peach,  he  destroys  the  form  of  the 
peach,  but  the  amount  of  matter  in  existence  is  not 
reduced.  Furthermore,  much  consumption  does  not 
even  change  the  form  of  the  thing  consumed.  The 
owner  of  a  painting  appropriates  but  he  does  not 
destroy  or  even  alter  the  form  of  the  thing  consumed. 
Furthermore,  consumption  does  not  necessitate  ap- 
propriation. The  owner  of  a  painting  is  not  the 
only  one  who  consumes  it,  that  is,  derives  satisfac- 
tion from  it. 

Production. — Production  logically  comprises  all 
the  processes  that  are  necessary  to  give  the  consumer 
the  goods  and  services  he  desires.  Production  in 
the  economic  sense  does  not  mean  the  actual  creation 
of  matter.  Man  cannot  bring  matter  into  being; 
he  can  merely  change  its  form.  Tables  and  chairs 
are  made  out  of  wood,  which  in  turn  comes  from  the 
trees ;  but  the  trees  grow  and  are  not  the  creation  of 
man.  Production  does  not  consist  in  changing  only 
the  form  of  goods;  it  includes  also  the  placing  and 
keeping  of  goods  so  as  to  give  the  consumer  his  sat- 
isfactions where  and  when  he  wants  them.  Chang- 
ing the  form  of  goods  is  called  the  production  of 
form  utilities,  whereas  changing  their  location  and 
keeping  them  until  they  are  needed  are  called  the 
production  of  place  and  time  utilities.  The  econo- 
mist, therefore,  maintains  that  what  he  calls  place 


20   ECONOMICS  FOR  THE  ACCOUNTANT 

and  time  utilities  are  as  important  as  form  utilities. 
The  retailers,  the  jobbers,  the  railroads,  and  the  cold 
storage  warehouses  are  as  truly  producing  agencies 
as  are  the  farmers  and  manufacturers,  even  though 
they  merely  store  and  transport  goods  and  do  noth- 
ing to  change  their  form.^ 

Some  goods  that  provide  the  consumer  with  satis- 
faction do  not  occupy  very  much  of  the  economist's 
attention.  The  economist  is  only  interested  in  those 
goods  for  which  the  consumer  is  willing  to  pay  a 
price.  Some  goods,  such  as  air  and  sunshine,  are 
called  free  goods  because  they  are  not  usually  limited 
in  amount  and,  therefore,  do  not  command  a  price. 
Goods  that  are  limited  in  amount  and  that  con- 
sumers desire  (usually  have  to  buy)  are  called  eco- 
nomic goods.  Economic  goods  usually  have  to  be 
produced,  although  mere  scarcity  plus  desiredness 
are  sufficient  qualifications.  The  distinction  be- 
tween free  goods  and  economic  goods  is  not  always 
well  defined.  Sea  shells,  wild  mushrooms,  and 
blackberries  may  be  free  goods  for  persons  in  cer- 
tain districts,  and  may  be  obtained  through  the  ex- 
penditure of  only  personal  labor;  but  for  consumers 

*  The  accountant 's  conception  of  production  is  often  narrow  and 
confined  to  the  direct  creation  of  form  utilities.  The  workers  in  a 
factory  are  sometimes  called  ' '  productive  laborers ' '  whereas  the 
members  of  the  office  force  are  spoken  of  as  "non-productive 
laborers,"  Without  the  clerical  force  the  creation  of  even  form 
utilities  would  be  practically  impossible;  thus,  the  economist  makes 
no  such  distinction.  Furthermore,  the  accountant  does  not  consider 
the  selling  expense  as  a  part  of  the  "cost  of  production";  but  the 
economist  insists  that  selling,  which  represents  the  arrangement  for 
the  creation  of  place  and  probably  time  utilities,  is  as  productive  as 
the  factory  laborer's  direct  work  on  the  product.  Thus,  clerical 
work,  selling,  jobbing,  and  transportation  are  as  much  production  as 
farming  or  the  direct  creation  of  form  utilities. 


CONSUMPTION  AND  PRODUCTION  21 

in  tlie  heart  of  a  great  city  they  would  be  economic 
goods.  Many  economic  goods  that  embody  no  form 
utilities  but  only  place  and  time  utilities  may  have 
been  free  goods  in  their  original  habitat. 

Some  economic  goods  are  produced  that  do  not  in 
themselves  gratify  the  consumer's  wants.  A  ma- 
chine for  making  shoes  is  such  a  good.  It  fills  the 
need  of  the  shoe  manufacturer,  as  producer,  but  not 
as  consumer.  The  shoes  made  by  this  machine 
would  gratify  the  consumer's  wants  directly  and,  for 
that  reason,  are  called  consumption  goods.  The  ma- 
chine, which  is  merely  used  in  the  production  of 
another  good,  is  termed  a  production  good.  It  will 
be  shown  later  that  production  goods  are  usually 
called  capital  goods. 

It  has  been  explained  that  practically  every  eco- 
nomic good  has  to  be  produced;  either  its  form  has 
to  be  changed  or  it  has  to  be  transported  where,  or 
kept  until,  it  is  needed.  The  farm,  the  mine,  the  rail- 
road, the  steamship,  the  warehouse,  the  dealer's 
shelves,  all  are  scenes  of  production.  Economics 
divides  the  agents  or  factors  of  production  in  four 
classes :  laborers,  owners  of  land  and  capital  goods, 
capitalists,  and  entrepreneurs.^  An  analysis  of  these 
factors  of  production  and  of  the  services  they  per- 
form is  absolutely  necessary  for  an  understanding  of 
our  economic  system. 

Labor. — Production  requires,  first  of  all,  human 
effort,  both  mental  and  physical.  Practically  all 
human  effort,  whether  mental  or  physical,  is  classed 

'  This  classification  is  somewhat  different  from  those  usually  given 
in  the  texts,  but  its  value  will  soon  be  evident. 


22   ECONOMICS  FOR  THE  ACCOUNTANT 

as  labor.  Economics  puts  the  farm  laborer,  the 
bricklayer,  the  brakeman,  the  salesman,  and  the  min- 
ing engineer  in  the  same  category:  they  are  all 
laborers,  and  their  remunerations  are  called  wages. 

In  the  earliest  stages  of  civilization  the  family 
could  produce  practically  all  the  things  it  needed. 
Probably  the  most  fundamental  distinction  between 
such  a  simple,  Crusoe  system  and  our  complicated 
economic  organization  is  to  be  found  in  the  greater 
division  of  labor  that  prevails  to-day.  In  the  modern 
factory  system  of  production  nearly  every  laborer 
specializes  in  one  relatively  simple  process.  The 
worker  in  a  modern  shoe  factory  does  not  make  an 
entire  shoe:  he  completes  only  one  part  of  it  and 
then  hands  it  over  to  another  worker  who  adds  some- 
thing more.  This  division  of  labor  and  the  resulting 
specialization  of  function  have  enabled  the  same 
number  of  men  to  produce  a  larger  quantity  of 
goods  in  the  same  time. 

Land. — ^But  human  efforts,  alone,  will  not  avail  in 
production;  nature  must  do  her  part.  Man  cannot 
even  exist  without  the  air  and  sunshine,  but  indis- 
pensable as  they  are,  they  are  free  and,  therefore, 
are  not  classed  independently  as  economic  factors  of 
production.  Only  those  factors  of  production  are 
considered  economic  that  are  so  limited  that  they 
must  be  paid  for.  Although  producers  do  not  have 
to  pay  for  air  and  sunshine,  they  usually  have  to 
secure  a  plot  of  ground  or  the  temporary  right  to 
stay  on  a  plot  of  ground  before  they  can  produce,  and 
with  the  ground  goes  the  indispensable  air  and  sun- 
shine.  All  these  natural  agents  are  classed  in  the  one 


CONSUMPTION  AND  PRODUCTION  23 

category,  land;  the  renumeration,  which  producers 
give  to  the  owners  of  land  for  its  use,  is  the  most 
important  kind  of  rent. 

Capital  Goods. — It  might  appear  that  nature,  con- 
trolled directly  by  human  efforts,  would  supply  all 
of  man's  desires.  In  a  sense,  this  is  true,  but  nature 
is  formidable  and  man's  body  is  weak.  His  brain 
has  enabled  him  to  contrive  tools  with  which  to  pro- 
duce the  form,  place,  and  time  utilities  necessary  for 
his  satisfactions.  Thus,  when  he  wishes  to  dig  into 
the  soil,  he  does  not  go  to  it  directly  with  his  hands, 
but  fashions  a  spade,  and  before  he  attempts  to  re- 
move boulders,  he  obtains  dynamite.  It  will  be  re- 
membered that  such  things  as  spades  and  dynamite, 
when  used  by  producers  for  making  consumption 
goods,  are  called  production  goods.  When  used  in 
production,  they  are  called  capital  goods.  Capital 
goods,  then,  are  all  the  goods  and  instruments  used 
by  the  producer  in  the  productive  process.  The  flour 
miller's  wheat  and  sacks,  as  well  as  his  machinery, 
are  his  capital  goods. 

Before  a  producer  can  produce  on  any  considerable 
scale,  he  must  obtain  the  capital  goods  necessary  for 
his  production.  If  he  needs  a  building  and  ma- 
chinery and  borrows  them  from  those  who  own  them 
he  pays  rent  or  royalty  for  their  use  just  as  he  does 
when  he  needs  and  leases  land.  For  this  reason,  the 
business  man  seldom  sees  any  distinction  between 
capital  goods  and  land.  As  a  matter  of  fact,  the 
most  significant  distinction  between  them  lies  in  the 
fact  that  capital  goods  are  commonly  produced  by 
man's  efforts,  whereas  land  is  not.     Furthermore, 


24   ECONOMICS  FOR  THE  ACCOUNTANT 

the  stock  of  capital  goods  can  be  increased  but  the 
amount  of  land  cannot.  Land  would  be  a  free  good 
even  to-day  were  it  not  for  the  physical  limitations 
of  space  and  time.  When  land  is  improved,  it  repre- 
sents a  combination  of  land  and  capital  goods. 

Capital. — ^As  a  matter  of  fact,  however,  capital 
goods  are  not  usually  rented;  the  producer  must 
purchase  them.  This  is  often  just  as  true  of  land. 
He  purchases  them  with  what  is  called  capital,  which 
is  expressed  in  monetary  terms.  Producers  some- 
times consider  their  '^ capital"  as  the  aggregate  of 
their  capital  goods,  and  sometimes  as  the  value  of 
this  aggregate.  They  express  these  capital  goods  in 
monetary  terms  because  in  no  other  way  could  they 
add  together  such  unlike  things  as  machinery,  raw 
materials,  buildings,  and  land.  Such  conceptions  of 
capital  might  lead  to  the  belief  that  it  is  directly 
productive.  The  best  way  to  define  capital  is  by 
genetic  definition,  that  is,  to  tell  how  it  is  created. 

When  those  who  help  to  produce  receive  recom- 
pense, they  are  commonly  rewarded  in  units  of  the 
medium  of  exchange,  that  is,  dollars  and  cents.  This 
money  has  no  value  in  itself  except  in  so  far  as  it 
represents  a  claim  on  desirable  goods  or  service.  If 
the  claimants  in  distribution  can  forego  the  pleasure 
of  spending  their  money,  they  save  it  and  amass 
what  is  called  capital.  This  capital  is  not  necessarily 
money,  that  is  pieces  of  gold;  it  is  merely  a  claim  on 
goods,  but  it  is  always  expressed  in  terms  of  money 
because,  as  has  been  explained,  money  is  the  only 
common  denominator  for  all  goods  and  because 
money  always  represents  a  claim  on  goods.    Capital, 


CONSUMPTION  AND  PRODUCTION  25 

then,  from  the  point  of  view  of  its  owners  represents 
accumulated  and  postponed  claims  on  consumption 
goods,  expressed  in  terms  of  money.  Wlien  it  is 
transferred  from  its  o^Tiers  to  producers,  it  becomes 
productive  capital  and  its  principal  use  is  for  the 
purchase  of  capital  goods.  Its  owners  are  only  will- 
ing to  forego  their  claims  on  consumption  goods  and 
transfer  them  to  producers,  if  they  have  reason  to 
believe  that  these  claims  will  be  returned  to  them  in 
the  future  and  that  they  will  receive  interest. 
Interest,  then,  is  the  payment  made  to  the  capitalist 
for  the  use  of  capital. 

The  producer  takes  this  capital,  or  these  post- 
poned claims  on  goods,  and  obtains  capital  goods 
or  land  therewith.  (The  other  use  of  capital,  namely 
for  the  payment  of  wages,  interest,  rent,  and  profit, 
will  be  explained  later.)  From  the  producer's  point 
of  view  the  capital  is  thereby  dissipated  by  being 
given  to  the  manufacturers  or  sellers  of  the  capital 
goods,  but  from  the  point  of  view  of  the  owners  of 
capital,  it  remains  intact.  Their  claims  have  now 
become  contingent  claims  on  definite  units  of  capital 
goods,  which  legally,  however,  are  in  the  possession 
of  the  producer.  The  producer  still  must  maintain 
the  concept  of  capital,  as  it  forms  the  basis  on  which 
he  pays  interest.  Capital,  then,  is  an  aggregate  of 
postponed  claims  to  consumption  goods  and  is  the 
basis  of  interest  payments,  whereas,  capital  goods 
are  the  physical  instruments  used  in  production.' 

Now,  as  already  stated,  capital  must  not  be  con- 

•  See  Chapter  XI  for  the  full  explanation  of  capital  and  capital 
goods. 


26   ECONOMICS  FOR  THE  ACCOUNTANT 

fused  with  money,  although  it  is  always  expressed 
in  monetary  units,  and  although  like  money,  it  repre- 
sents a  claim  on  goods.  If  all  the  tools,  machinery, 
land,  raw  materials,  etc.  were  expressed  in  money 
value  and  added  together,  they  would  amount  to 
very  much  more  than  the  total  quantity  of  the 
medium  of  exchange  existing  at  that  time,  even 
though  it  included  coins,  bank  notes,  drafts,  and 
checks.  Capital  is  not  synonomous  with  money :  the 
total  claims  of  those  who  forego  consumption  can  be 
expressed  in  monetary  units  but  they  are  much 
greater  than  the  quantity  of  the  medium  of  exchange 
in  existence.^  Bonds  and  stocks  may,  and  usually 
do,  represent  capital  but  they  are  not  money,  that 
is  they  do  not  circulate  as  media  of  excliange  and  are 
not  legal  tender.'^ 

The  Entrepreneur. — It  would  appear  that  human 
efforts,  the  gifts  of  nature,  and  the  instruments 
fashioned  by  man  are  all  that  are  necessary  in  pro- 
duction. In  the  modern  economic  organization  of 
society,  however,  there  is  another  factor,  the  entre- 
preneur. The  entrepreneur  is  the  producer  about 
whom  so  much  has  been  already  said.  He  is  the  man 
(or  group  of  men)  in  a  business  organization  who 
controls  its  policies  because  he  has  legal  title  to  its 
capital  goods  and  its  product.  He  is  not  necessarily 
the  capitalist,  for  he  may  borrow  aU  the  capital  he 
uses.  If  he  does  invest  some  or  all  of  the  capital,  he 
is  an  entrepreneur-capitalist.    In  a  private  business 

'  See  Chapter  XI  for  the  full  explanation  of  capital  and  capital 
goods. 

'  See  Chapter  VII. 


CONSUMPTION  AND  PRODUCTION  27 

the  entrepreneur  is  the  "boss";  in  a  partnership,  the 
partners ;  in  a  corporation,  the  common  stockholders. 
It  might  seem  as  if  the  president  of  a  corporation 
corresponded  to  the  "boss"  in  a  private  firm;  but  a 
little  reflection  will  show  that  the  stockholders  of  a 
corporation  are  legally  the  "boss,"  because  they 
own  the  business,  the  capital  goods,  and  product,  and 
because  they  control  the  policy  of  the  corporation. 
The  president  is  merely  a  salaried  laborer,  hired  by 
the  stockholders. 

It  has  been  stated  that  in  the  modern  corporation, 
the  common  stockholders  constitute  the  entrepre- 
neur. As  the  great  bulk  of  the  businesses  in  the 
United  States  to-day  are  corporations,  it  seems  neces- 
sary to  consider  somewhat  in  detail  this  form  of 
business  organization.  The  corporate  form  of  organ- 
ization has  been  developed  to  obviate  certain  difficul- 
ties of  the  private  firm  and  partnership.  A  corporate 
charter  enables  a  business  organization  to  continue 
automatically  after  the  death  of  its  owners,  whereas 
a  partnership  has  to  be  dissolved  and  reorganized  if 
one  of  the  partners  dies.  A  corporation  is  owned  by 
a  number  of  stockholders,  who  holds  stocks  or  shares, 
usually  valued  at  $100  each,  as  evidence  of  owner- 
ship. A  corporation  can  obtain  capital  by  selling 
these  stocks  to  those  who  desire  to  become  partners, 
but  the  stockholders  are  not  personally  liable  for  the 
debts  of  each  other  or  for  the  debts  of  the  corpora- 
tion. This  limited  liability  of  the  stockholders  makes 
the  corporation  a  far  more  desirable  form  of  busi- 
ness organization  than  the  partnership,  where  the 


28   ECONOMICS  FOR  THE  ACCOUNTANT 

partners  are  personally  liable  for  the  debts  of  the 
business. 

Every  holder  of  a  common  stock  has  a  vote  and 
the  holders  of  the  majority  of  the  common  stocks 
have  control  of  the  corporation.  The  common  stock- 
holders usually  obtain  their  common  stock  by  pur- 
chase; thus,  they  supply  the  corporation  with  capital 
when  they  become  the  entrepreneur.  If  a  capitalist 
purchases  1000  shares  at  $100  each,  he  supplies  the 
corporation  with  $100,000  capital.  For  this  reason, 
the  common  stockholders  are  usually  capitalists  as 
well  as  entrepreneur,  but  if  they  supplied  the  cor- 
poration with  no  capital  when  they  received  their 
common  stocks,  they  have  the  entrepreneurial  but 
not  the  capitalistic  function.  The  entrepreneurial 
function,  then,  consists  in  having  the  majority  vote 
in,  or  control  of,  the  corporation.  Furthermore,  the 
stockholders,  even  if  they  do  not  supply  any  capital, 
legally  own  the  business,  that  is  the  capital  goods 
and  the  product.  If  the  business  earns  more  than 
enough  to  pay  expenses,  the  stockholders  may  re- 
ceive a  dividend;  if  nothing  is  earned,  however, ' 
nothing  can  be  paid.  The  stockholder,  therefore, 
takes  his  chances. 

If  a  corporation  desires  to  obtain  capital  without 
selling  common  stock  and,  thereby,  increasing  the 
number  of  partners,  it  can  borrow  from  the  banks 
on  notes  or  loans  or  it  can  sell  bonds  or  preferred 
stock.  But  on  all  such  borrowings  it  must  pay  a 
fixed  rate  of  interest.  The  bondholders  supply  capi- 
tal, but  they  have  no  vote;  in  lieu  of  this,  they 
demand  an  assured  interest  return.     If  the  bonds 


CONSUMPTION  AND  PRODUCTION  29 

issued  are  mortgage  bonds,  the  bondholders  have  a 
right  to  foreclose,  that  is,  take  over  and  sell  the 
specific  capital  goods  mortgaged,  in  the  event  that 
their  interest  is   not  paid.     The  preferred  stock- 
holders in  most  modern  companies  are  also  supposed 
to  receive  a  fixed  return,  called  a  dividend,  but  really 
interest.    Although  the  preferred  stockholders  have 
no  mortgage,  and  cannot  sell  a  specified  part  of  the 
company's  property  if  their  interest  is  not  paid,  their 
interest  is  usually  cumulative,  that  is,  if  the  7  per 
cent  due  them  this  year  is  not  paid,  they  are  entitled 
to    receive    14    per    cent    next    year,    before    any 
dividends  on  the  common  stock  can  be  declared. 
Furthermore,   although   the   common   stockholders 
have  the  vote  and  the  preferred  stockholders  have 
no  voice  in  the  management  as  long  as  they  receive 
their  specified  return,  the  preferred  stockholders  are 
sometimes  given  the  voting  control  of  the  corpora- 
tion if  their  interest  or  preferred  dividend  is  not 
paid.    This  contingent  right  to  vote  is  not  an  evi- 
dence of  partnership,  but  is  merely  a  club  over  the 
corporation  and  serves  much  the  same  purpose  that 
the  bondholder's  right  to  foreclose  under  a  mortgage 
does. 

The  bondholders  and  preferred  stockholders 
are  pure  capitalists  and  have  none  of  the  entre. 
preneur's  function.  The  sinking-fund  provisions, 
which  are  intended  to  wipe  out  the  bonds  and  pre- 
ferred stocks  year  by  year  until  they  are  all  can- 
celed, show  that  these  two  classes  are  not  partners 
but  creditors.  Thus,  although  the  common  stock- 
holders are  entrepreneur  and  may  be  capitalists  as 


30   ECONOMICS  FOR  THE  ACCOUNTANT 

well,  the  preferred  stockholders  and  the  bondholders 
are  capitalist  but  not  entrepreneur. 

In  the  days  when  most  producing  units  were  small 
unincorporated    businesses    and    partnerships,    the 
function  of  the  entrepreneur  was  definitely  vested  in 
one  or  two  men,  but  in  these  days  of  incorporation 
the  problem  is  more  complicated;  the  stockholders 
legally  own  the  product  and  the  capital  goods,  it  is 
true,  but  in  most  cases  only  a  small  group  of  them 
control  the  policy  of  the  company.    Furthermore,  the 
voting  trust  has  complicated  matters  still  further; 
in  a  voting  trust  the  stockholders  delegate  their  vot- 
ing rights  to  the  voting  trustees  and  thereby  relin- 
quish their  control  for  a  temporary  period,  at  least. 
Generally  speaking,  the  function  of  the  entrepreneur 
is  divided  between  the  controlling  stockholders  of  a 
corporation  although  all  of  the  stockholders  have 
some  of  the  entrepreneurial  function  in  that  they  are 
joint  owners  of  the  capital  goods  and  the  product. 
A  more  complete  exposition  of  the  entrepreneur  and 
his  functions  will  be  set  forth  in  Chapter  XII. 

The  accountant  often  confuses  the  entrepreneur 
and  the  capitalist.  Although  the  entrepreneur  holds 
title  to  the  capital  goods,  he  does  not  always  supply 
the  capital,  and  in  so  far  as  he  does  so,  he  is  a  capi- 
talist and  not  an  entrepreneur .  It  should  be  empha- 
sized that  the  capitalist  owns  the  capital,  whereas 
the  entrepreneur  has  legal  title  to  the  capital  goods. 
The  fact  that  the  two  functions  are  so  often  embodied 
in  one  man  is  no  reason  for  confusing  them.  The 
promoter,  who  may  or  may  not  he  the  entrepreneur, 

usually  secures,  or  has  someone  else  to  secure,  the 


CONSUMPTION  AND  PRODUCTION  31 

land  and  capital  and  then  brings  the  capital  goods 
and  the  labor  together;  but  the  entrepreneur  is  not 
necessarily  a  capitalist,  a  landowner,  or  a  laborer, 
and  yet  he  may  be  all  three.  If  he  gives  his  time 
and  actually  works  in  his  business  after  it  has  been 
organized,  he  is  a  laborer  and  usually  receives  a 
salary  for  his  efforts.  But  the  entrepreneur  may 
have  no  active  connections  with  his  business,  as  for 
example,  the  majority  of  the  common  stockholders 
of  modern  corporations,  who  merely  sign  a  proxy 
once  or  twice  a  year.  In  that  case,  then,  his  only 
functions  ivould  be  the  control  of  the  policy  through 
the  ownership  of  the  capital  goods  and  the  product. 
The  Division  of  Labor,  Distribution,  and  Ex- 
change.— In  the  simplest  kind  of  economic  system, 
each  man  or  each  family  produced  independently 
all  the  things  that  were  needed.  The  consumer 
directly  consumed  the  goods  that  he,  himself,  pro- 
duced. In  our  modern  complicated  economic  organ- 
ization, few  persons  produce,  or  help  to  produce, 
more  than  one  kind  of  thing.  Indeed,  most  laborers 
are  expected  to  complete  only  one  small  part  of  a 
complicated  manufacturing  process.  It  has  already 
been  explained  that  such  a  division  of  labor  makes 
possible  a  great  increase  in  product,  but  it  obviously 
complicates  the  division  of  the  product.  When 
Robinson  Crusoe  worked  alone,  all  that  he  produced 
was  his;  but  when  Friday  helped  him  a  division  of 
the  product  became  necessary.  The  problem  became 
even  more  difficult  when  the  product  had  to  be 
divided  between  the  laborers;  the  owners  of  the  land 
or  capital  goods,  who  rented  them  to  the  entre- 


32   ECONOMICS  FOR  THE  ACCOUNTANT 

preneur;  the  capitalist,  who  supplied  the  capital,  and 
the  entrepreneur,  himself.  Obviously,  these  four 
factors  of  production  would  have  found  it  incon- 
venient to  receive  remuneration  for  their  help  in  the 
commodities  they  were  cooperating  to  produce. 
Some  farm  laborers  are  paid  in  kind,  but  ordinarily 
laborers  are  paid  money  wages;  owners  of  land  and 
capital  goods  are  paid  money  rents  or  royalties; 
capitalists  are  paid  money  interest;  and  entre- 
preneurs retain  money  profits.  This  money  is  sur- 
rendered to  the  entrepreneur  by  the  consumers  and 
is  called  by  him, ' '  Sales, ' '  but  by  them  prices.  Price, 
therefore,  is  the  sum  of  wages,  rent,  interest,  and 
profit.  The  study  of  the  division  of  price  is  called 
** distribution,"  and  the  study  of  the  medium  of 
exchange,  money,  is  called  "exchange."  The  four 
subdivisions  of  economic  theory,  then,  are :  consump- 
tion, production,  distribution,  and  exchange. 

Another  Definition  of  Economics. — Economics  is 
sometimes  defined  as  ''the  science  that  treats  of 
phenomena  from  the  standpoint  of  price."  °  This 
definition  can  be  easily  reconciled  with  the  first  one 
given  on  page  18  when  it  is  realized  that  price  is 
what  the  consumer  must  give  in  order  to  obtain  the 
satisfaction  of  his  desires  (consumption) ;  it  is  what 
the  producer  receives  for  the  efforts  expended  (pro- 
duction) ;  it  is  the  return  divided  between  the  four 
factors  of  production  (distribution) ;  it  is  expressed 
in  terms  of  money,  and,  as  will  be  shown  in  Chapter 
VII,  bears  a  close  relation  thereto  (exchange).  The 
accountant,  too,  is  interested  in  price,  or  ''Sales," 

•  H.  J.  Davenport,  Economics  of  Enterprise,  page  25. 


CONSUMPTION  AND  PRODUCTION  33 

that  is,  the  sum  total  of  the  prices  received.  He 
analyzes  price  somewhat  differently;  he  considers 
price  the  sum  of  cost  and  profit,  cost  being  what  the 
entrepreneur  pays,  and  profit  what  he  receives. 
Although  cost  is  analyzed  both  on  the  Profit  and 
Loss  account  and  in  the  Cost  Statement,  the  classifi- 
cation of  the  accountant  differs  from  that  of  the 
economist.  It  will  be  sho^m  that  the  fundamental 
reason  for  this  difference  lies  in  difference  in  the 
economic  and  the  accounting  conceptions  of  cost.^ 

» See  Chapter  VIII. 


CHAPTER  IV 

DISTRIBUTION 

Distribution  and  Marketing. — Distribution  is  the 
branch  of  economics  that  deals  with  the  returns 
received  by   those   who   aid   in  production.     The 
laborers,  the  landowners,  the  capitalists,  and  the 
entrepreneurs  are  the  claimants  in  distribution,  and 
the  explanation  of  their  shares,  wages,  rent,  interest, 
and  profit,  is   one  of  the  principal  tasks  of  the 
economist.    Distribution  should  not  be  confused  with 
marketing,  which  considers  the  movement  of  prod- 
ucts from  the  producer  to  the  consumer.    It  might 
seem  that  when  laborers  are  paid  in  kind,  as  on  a 
farm,  the  two  problems  of  distribution  and  market- 
ing merge  into  one.     If  the  laborer  receives  com- 
modities in  payment  for  his  services  and  consumes 
them,  the  process  of  distribution  has  become  the 
marketing  process.    However,  it  is  doubtful  whether 
many  laborers  to-day  could  satisfy  all  their  wants 
through  the  consumption  of  the  commodities  they 
helped  to  produce.     A  farm  laborer  might  receive 
all  the  food  he  needed,  but  he  would  require  many 
things,  other  than  food,  and  for  them  he  would  be 
forced  to  give  a  part  of  the  food  commodities  he 
received  as  wages.    Marketing  would  consider  the 
ultimate  destination  of  the  food  commodities  the 

34 


DISTRIBUTION  35 

farm  laborer  received  as  wages,  but  distribution 
would  merely  treat  them  as  a  share  of  the  total 
production  and  would  not  consider  them  after  they 
had  passed  out  of  the  laborer's  hands.  Inasmuch  as 
most  laborers,  as  well  as  the  other  factors  of  produc- 
tion, receive  payment  in  money  and  not  in  kind,  for 
the  obvious  reasons  that  have  been  suggested  on 
page  32  and  will  be  elaborated  in  Chapter  VI,  dis- 
tribution is  the  study  of  the  division  into  wages, 
rent,  interest,  and  profit  of  the  money  prices  paid 
by  consumers  to  entrepreneurs,  and  marketing  is 
merely  concerned  with  the  movement  of  goods  from 
the  producer  through  the  middleman  to  the  con- 
sumer. Whereas  farming,  mining,  and  manufactur- 
ing are  largely  concerned  with  the  creation  of  form 
utilities,  marketing  is  more  definitely  concerned  with 
the  creation  of  place  and  time  utilities,  but  market- 
ing is,  nevertheless,  production  and  not  distribution. 
Whether  a  commodity  is  moving  from  the  producer 
to  the  consumer  mth  the  least  expenditure  of  effort 
and  whether  there  are  so  many  unnecessary  middle- 
men that  the  producer's  price  is  loaded  with  too 
many  margins  before  the  commodity  finally  reaches 
the  consumer  are  the  problems  attacked  by  a  market- 
ing study. 

The  problems  of  distribution  are  of  a  very  dif- 
ferent kind.  Why  do  the  different  factors  in  produc- 
tion receive  their  shares  in  distribution?  Why  are 
laborers  paid  wages?  Why  are  rent  and  interest 
paid?  What  services  do  entrepreneurs  perform  in 
order  to  earn  their  profit?  Why  do  wages  rise  while 
rents  or  interest  may  be  falling?    What  explains  the 


36   ECONOMICS  FOR  THE  ACCOUNTANT 

total  wages  paid  to  laborers  in  an  industry?  What 
determines  the  total  amount  of  the  shares  paid  the 
other  factors,  the  owners  of  land  and  capital  goods, 
the  capitalists,  the  entrepreneurs  ?  How  are  the  dif- 
ferences in  wages,  rents,  interest,  and  profits  to  be 
explained?  These  are  some  of  the  most  important 
questions  that  any  theory  of  distribution  should 
attempt  to  answer. 

The  Productivity  Theory  of  Distribution. — If 
there  is  any  one  principle  that  is  more  fundamental 
than  any  other  in  the  theories  of  distribution,  as  set 
forth  by  most  economists,  it  is  the  ''productivity^' 
explanation  of  the  shares  in  distribution.  On  the 
third  page  of  Professor  J.  B.  Clark's  Distribution  of 
Wealth,  he  makes  the  following  statement:  ".  .  . 
where  natural  laws  have  their  way,  the  share  of 
income  that  attaches  to  any  productive  function  is 
gauged  by  the  actual  product  of  it.  In  other  words, 
free  competition  tends  to  give  to  labor  what  it 
creates,  to  capitalists  what  capital  creates,  and  to 
entrepreneurs  what  the  coordinating  function 
creates."  Many  economists  assume  the  justice  of 
this  principle,  which  other  economists,  including  the 
Socialists,  challenge.  The  ethics  of  this  assumption 
cannot  be  discussed  in  this  book,  but  the  failure  to 
treat  it  constitutes  no  reason  for  the  belief  that  it 
cannot  be  defended. 

The  productivity  theory  of  distribution,  then, 
maintains  that  in  a  truly  competitive  system  laborers 
tend  to  receive  in  wages  the  equivalent  of  that  speci- 
fic part  of  the  product  that  their  services  create, 
that  the  owners  and  renters  of  land  or  capital  goods 


DISTRIBUTION  37 

tend  to  receive  in  rents  or  royalties  what  their  land 
or  capital  goods  produce,  that  the  capitalists  tend 
to  get  in  interest  the  productivity  of  the  capital 
goods  purchased  with  their  capital,  and  that  the 
entrepreneur  gets  approximately  in  profits  what  he 
adds  to  the  product.  In  concrete  terms,  if  a  laborer, 
working  on  a  piece  of  land  with  no  instrument  (capi- 
tal goods),  produces  20  units  of  product,  the  20 
units  would  be  the  result  of  the  land's  productivity 
and  of  the  laborer's  productivity,  and  if  it  were 
divided  between  the  landowner  and  the  laborer,  it 
might  be  said  to  represent  wages  and  rent,  equal  to 
the  product  of  the  laborer  and  the  land.  If  a 
machine  were  employed,  the  productivity  might  be 
increased  to  30  units ;  then,  10  units  would  be  imput- 
able to  the  machine,  and,  according  to  the  produc- 
tivity theory,  approximately  10  units  of  product 
would  represent  either  rent  or  royalty  paid  for  the 
use  of  the  machine,  if  it  were  borrowed,  or  interest 
on  the  capital  expended,  if  the  machine  were  bought. 
Later,  if  an  entrepreneur  were  assumed  to  increase 
the  productivity  of  the  combination  of  labor,  land, 
and  capital  goods  to  40  units  of  product  by  some 
adroit  innovation,  the  profit  he  would  tend  to  get 
would  be  the  10  units  he  may  be  said  to  have  created. 
Although,  if  certain  assumptions  are  made,  the 
productivity  theory  seems  most  reasonable  and,  to 
the  author,  not  unethical,  it  is  a  difficult  theory  to 
prove   or   even   demonstrate.^    Professor   John   B. 

*  With  regard  to  the  assumptions  referred  to,  if  the  laborer  is  to 
get  what  he  produces,  his  bargaining  power  must  equal  that  of  his 
employer.  This  is  also  true  of  the  bargaining  powers  of  the  other 
factors.    The  disparities  in  the  laborer's  and  entrepreneur's  bargain- 


38   ECONOMICS  FOR  THE  ACCOUNTANT 

Clark  and  some  of  his  pupils  have  made  the  most 
sustained  attempt  to  demonstrate  and  prove  the 
principle  that  free  competition  tends  to  give  each 
factor  what  it  produces,  and  the  logic  he  uses  can  be 
found  in  his  Distribution  of  Wealth  J'  One  corollary 
of  the  productivity  theory,  which  is  somewhat  easier 
to  demonstrate,  is  the  principle  that  laborers  of  dif- 
ferent efficiencies  tend  to  get  wages  graded  accord- 
ing to  their  relative  productivities. 

Wages. — Wages  and  salaries  constitute  the  share 
of  labor.  Before  production  begins  they  are  fixed 
by  contract  between  labor  and  the  entrepreneur  or 

ing  powers  have  resulted  in  the  collective  bargaining  of  the  trade 
unions,  which  at  times  may  get  for  the  laborers  more  than  they 
produce.  The  price  agreements  of  entrepreneurs  and  their  monopo- 
listic control  of  industry  have  often  secured  greater  profits  for  them 
than  their  productivities  could  have  warranted.  Thus,  in  many  ways, 
competition  is  not  free  and  the  factors  do  not  even  tend  to  get  their 
productivities.    This  is  all  explained  in  detail  in  Chapter  XIII. 

*  The  productivity  theorist  argues  that  a  producer  will  continue  to 
obtain  laborers  and  capital  for  capital  goods,  including  land,  until  he 
reaches  a  point  where  the  last  unit  of  capital  goods  and  the  last 
laborer  will  just  pay  for  themselves,  that  is,  this  last  unit  of  capital 
goods  and  the  last  laborer  will  just  add  enough  to  the  product  to 
cover  the  interest  charge  and  the  wage  that  must  be  paid.  Then  if  he 
is  a  wise  producer,  he  will  hire  no  more  laborers  and  buy  no  more 
capital  goods.  This  last  laborer  is  called  the  marginal  laborer,  and 
the  last  unit  of  capital  goods  is  called  a  marginal  unit  of  capital 
goods.  Since  it  is  assumed  for  the  purpose  of  this  analysis  that  all 
the  laborers  are  of  equal  efficiency,  the  marginal  laborer  will  produce 
as  much  as  the  other  laborers,  and,  furthermore,  he  will  receive  a 
wage  equal  to  his  productivity,  because  he  is  defined  as  the  laborer 
who  just  pays  for  himself.  The  productivity  theory,  then,  goes  on  to 
show  that  all  laborers  cannot  be  assumed  to  be  equally  eflScient. 
Professor  Clark's  words  are  as  follows:  "A  skilled  worker  will,  of 
course,  always  create  more  wealth  than  an  unskilled  one.  ...  A 
good  instrument  will  also  produce  more  than  a  poor  one.  Such  a  good 
instrument,  however,  represents  more  units  of  capital  than  does  the 
poor  one;  all  that  we  have  claimed  for  competition  is  a  tendency  to 
put  the  different  units  of  capital  where  their  earnings  are  equal.  .  .  . 
In  like  manner,  a  laborer  of  a  high  grade  embodies  in  himself  more 
unita  of  labor  than  does  an  inferior  one."  Distribution  of  Wealth, 
page  106. 


DISTRIBUTION  39 

his  agents.  Laborers  and  salaried  officers  receive 
fixed  amounts  for  their  services  except  in  those  cases 
where  bonuses  are  given,  but  even  then  the  amounts 
received  do  not  necessarily  depend  upon  conditions 
in  the  market.  This  is  not  true  of  the  amounts 
received  by  the  laborers  in  a  profit-sharing  sys- 
tem, which  represent  a  combination  of  wages  and 
profits. 

There  are  a  number  of  theories  that  attempt  to 
explain  how  the  wages  of  labor,  as  a  whole,  and  how 
the  wages  of  laborers,  as  individuals,  are  determined, 
but  the  business  man  and  his  accountant  have  only 
of  late  become  interested  in  the  wage  problem. 
Naturally  the  employer  has  always  tried  to  pay  as 
little  as  he  could,  and  after  he  had  paid  it,  his 
accountant  merely  put  the  exact  amount  in  cost  and 
gave  it  no  further  consideration. 

It  would  be  impractical  here  to  describe  at  length 
all  the  different  theories  of  wages,  and  yet  it  would 
be  dogmatic  to  present  and  insist  upon  any  one. 
Although  the  productivity  theory,  which  has  already 
been  described  briefly,  has  had  a  great  effect  on  the 
thinking  of  American  economists  the  cost  of  living 
or  standard  of  living  theory  is  often  introduced  as 
a  qualification.  The  cost  of  living  theory  of  wages 
has  been  gaining  support  largely  for  the  reason  that 
free  competition,  assumed  by  the  productivity 
theory,  does  not  exist  and  as  a  result  labor  has  not 
always  been  receiving  what  it  produces.^  The  cost 
of  living  theory,  or  the  standard  of  living  theory, 
might  maintain,  however,  that  even  if  competitive 

» See  Chapter  XIII. 


40    ECONOMICS  FOR  THE  ACCOUNTANT 

conditions  actually  were  as  tliey  are  pictured  by 
the  marginal  productivity  theory,  and  even  if  labor 
tends  to  receive  what  it  produces,  this  share  may 
not  be  sufficient.  If  this  share  does  not  give  laborers 
a  living  or  a  decent  wage,  it  should  be  increased. 
Even  if  the  capitalists,  the  landowners,  or  the  entre- 
preneurs have  to  surrender  parts  of  their  shares, 
that  is,  the  results  of  their  productivities,  it  would  be 
better  for  them  to  do  so  than  to  have  laborers  under- 
paid. This  might  imply  a  less  rapid  growth  of 
capital,  but  even  so  it  would  be  preferable  to  under- 
paid laborers.  Furthermore,  laborers  with  a  higher 
standard  of  living  and  with  the  educational  oppor- 
tunities offered  by  increased  wages  would  probably 
become  more  efficient. 

It  has  been  assumed  by  many  economists  that 
wages  could  never  fall  below  a  certain  point  for  the 
reason  that  there  is  a  certain  minimum  necessary 
for  life  and  that  if  wages  did  fall  below  the  minimum 
of  subsistence,  the  consequent  decrease  in  the  supply 
of  labor  would  automatically  raise  wages.  However, 
it  has  come  to  be  realized  that  wages  may  fall  below 
a  decent  minimum  without  necessarily  causing 
deaths;  undervitalization  and  consequent  physical 
degeneration  may  affect  the  labor  supply  without 
necessarily  diminishing  its  size.  The  cost  of  living 
theory  of  wages  assumes  that  every  person  who 
plays  any  part  in  production  should  have  a  living 
wage.  The  minimum  wage,  then,  is  a  necessary  part 
of  any  economic  organization  and  should  be  enforced 
by  legislation  if  it  does  not  come  about  naturally. 
Above  the  minimum  of  subsistence,  wages  might  be 


DISTRIBUTION  41 

determined  in  mncli  the  same  way  as  tlie  produc- 
tivity theory  maintains.  However,  according  to  the 
cost  of  living  theory,  general  increases  in  prices 
should  be  followed  by  increased  wages.  Laborers 
should  not  be  forced  to  reduce  their  standards  of 
living  because  of  increases  in  the  price  level.  This 
theory,  therefore,  is  often  called  the  standard  of 
living,  rather  than  the  cost  of  living,  theory  of 
wages. 

Rent. — ^It  is  often  asked  why  a  man  should  be 
allowed  to  control  a  piece  of  land  in  much  the  same 
way  that  he  controls  his  bodily  efforts,  and  why  any 
other  man  should  have  to  pay  him  for  the  use  of  it. 
Land  is  not  created  by  human  efforts  and  would  be 
considered  a  free  good,  like  air,  were  it  not  limited. 
Some  undesirable  pieces  of  land,  undesirable  because 
they  are  barren  or  because  they  are  so  far  removed 
from  the  centers  of  population,  are  free  even  to-day. 
The  payment  of  rent  for  land  is  predicated  on  the 
principle  of  private  property,  which,  justifiable  or 
unjustifiable,  is  at  the  basis  of  our  present  economic 
organization.  In  practically  every  civilization  of  the 
world  a  man  has  been  allowed  to  hold  legal  title  to 
a  piece  of  land  if  he  were  the  first  to  claim  it,  and 
legal  title  has  always  implied  the  right  to  hold,  trans- 
fer, sell,  rent,  or  bequeath.  Many  feel  that  no 
individual  should  have  such  rights  over  the  gifts  of 
nature  unless  he  be  expected  to  improve  them,  and 
the  more  radical  contend  that  under  no  conditions 
should  individuals  be  permitted  to  own  land,  which 
they  did  not  produce  and  which  should  be  the  prop- 
erty of  society  as  a  whole.    Although  the  original 


42   ECONOMICS  FOR  THE  ACCOUNTANT 

owner  of  a  piece  of  land  may  have  no  just  claim  to 
it  other  than  priority,  all  subsequent  owners  who 
purchased  it  with  the  expenditure  of  capital  prob- 
ably have  a  better  justification  for  demanding  rent. 
Such  landowners  might  almost  be  classed  with  the 
capitalists,  who  saved,  inherited,  or  acquired  their 
capital,  because  their  purchase  of  the  land  is  no  dif- 
ferent from  the  purchase  of  capital  goods.  No  one 
would  deny  that  a  laborer  who  invested  his  savings 
in  land  should  be  entitled  to  a  return. 

The  productivity  theory  is  used  to  explain  rent 
as  well  as  wages.  One  principle  that  helps  to  explain 
the  difference  in  rents  is  a  corollary  of  the  produc- 
tivity theory  and  can  also  be  applied  to  profits.  It 
is  sometimes  called  the  differential  theory.  If 
marginal  land  be  defined  as  a  piece  of  land  that  it 
just  does  not  pay  to  cultivate,  because  it  is  so  poor, 
the  difference  between  the  product  that  could  be 
raised  on  this  piece  of  land  and  on  other  pieces  of 
land,  more  fertile,  would  represent  the  respective 
rents  for  the  more  fertile  pieces  of  land.  This  use 
of  the  term  *' marginal,"  as  in  marginal  land  or 
marginal  entrepreneur,  must  not  be  confused  with 
the  other  use  of  this  word.  The  marginal  laborer 
of  the  productivity  theory  was  the  last  laborer  the 
producer  could  afford  to  use,  and  was  assumed  to  be 
of  the  same  efficiency  as  his  other  laborers;  the 
marginal  land  of  the  differential  theory  is  the  rela- 
tively poor  land  just  at  the  margin  of  cultivation. 
All  the  other  pieces  of  land  command  rents  equal  to 
the  excess  of  their  productivity  over  the  marginal 
land.     Thus,  if  a  producer  undertook  to  cultivate 


DISTRIBUTION  43 

free  land  from  wliicli  he  could  just  earn  enough  to 
pay  interest  on  the  borrowed  capital,  wages  to  his 
laborers,  and  enough  for  his  own  scant  subsistence, 
he  would  be  cultivating  marginal  land  and  would  be 
in  no  position  to  pay  rent.  Any  land  from  which  the 
same  producer  with  the  same  help  and  instruments 
could  obtain  a  larger  crop  would  be  super-marginal 
land.  For  such  land  he  would  have  to  pay  rent,  and 
this  rent  theoretically  would  be  equal  to  the  dif- 
ference in  the  product  obtained  from  marginal  and 
super-marginal  land. 

Interest. — Whereas  wages  are  paid  to  laborers, 
and  rents  to  the  owners  of  land  and  capital  goods, 
interest  is  not  paid  to  the  entrepreneur,  who  has 
legal  title  to  the  capital  goods,  hut  to  the  capitalist 
who  allowed  the  capital  to  be  brought  into  existence 
by  foregoing  claims  to  consumption  goods.  Interest 
on  capital  is  commonly  determined  upon  in  advance 
by  the  entrepreneur  and  the  capitalist.  It  usually 
represents  a  fixed  percentage  of  the  capital  loaned. 
Thus,  when  the  capitalist  loans  a  business  capital 
by  buying  its  bonds,  he  receives  a  fixed  rate  of 
interest.  The  return  received  by  the  capitalist  who 
lends  a  corporation  capital  by  buying  its  stock  will 
be  considered  on  page  120. 

The  productivity  theory  maintains  that  the  rate 
of  interest  is  determined  by  the  productivity  of  the 
capital  goods  purchased  with  capital.  Some  econo- 
mists maintain  that  the  interest  rate  is  far  less 
affected  by  the  productivity  of  capital  than  by  the 
psychology  of  the  savers  or  capitalists.  For  example, 
frugal  .and  provident  persons  would  save  capital  in 


44   ECONOMICS  FOR  THE  ACCOUNTANT 

order  to  accumulate  a  bank  account  even  though 
they  were  to  receive  a  rate  of  interest  very  much 
lower  than  the  productivity  of  the  capital  goods 
obtained  through  the  use  of  their  capital.  It  is  often 
questioned  whether  the  rate  of  interest  has  as  great 
an  effect  on  the  accumulation  of  capital  as  is  usually 
implied  in  the  productivity  theory.  Certainly  the 
provident  would  provide  for  old  age  no  matter  how 
low  the  interest  rate  might  be.  Furthermore,  a  shift- 
less person  or  a  nation,  suddenly  grown  extravagant, 
might  not  forego  present  consumption  for  a  promise 
of  future  consumption,  no  matter  how  great  the  in- 
ducement, that  is,  the  interest  rate,  might  be. 

There  is  another  factor  that  influences  the  interest 
rate,  namely,  the  risk  the  capitalist  runs  of  not  being 
able  to  obtain  his  principal.  When  a  capitalist  lends 
his  money  to  a  speculative  industrial  corporation, 
he  demands  a  higher  rate  of  interest  than  he  would 
if  he  were  buying  a  safe  railroad  bond.  The  dif- 
ference in  the  two  rates  is  sometimes  called  a  pre- 
mium for  risk.* 

The  interest  rate  is  probably  determined  (1)  by 
the  frugality  of  those  who  receive  incomes  and  by 
the  premium  they  demand  for  postponing  present 
consumption;  (2)  by  the  risk  they  run  of  not  obtain- 
ing their  future  consumption;  and  (3)  by  the  produc- 
tivity of  the  capital  goods  the  producer  can  obtain 
with  the  use  of  their  capital.  It  is  to  be  hoped  that 
concrete  statistical  work  will  be  carried  on  in  the 
future  in  order  to  sharpen  our  conceptions  of  the 
factors  that  determine  the  rate  of  interest. 

*  This  matter  will  be  discussed  again  on  page  140. 


DISTRIBUTION  45 

Profit. — The  complete  discussion  of  profit  will  be 
postponed  until  Chapter  XII,  where  it  will  receive 
more  complete  treatment  than  any  of  the  other 
shares  of  the  claimants  of  distribution  have  yet 
received.  Profit,  the  share  of  the  entrepreneur,  is 
the  most  important  of  any  of  the  shares  from  the 
accountant's  point  of  view.  The  entrepreneur  has 
the  strategic  position  in  the  modern  organization  of 
industry,  and  the  accountant  is  his  agent.  The  entre- 
preneur theoretically  assembles  the  other  factors  of 
production,  directs  the  productive  process,  collects 
from  the  consumers,  and  pays  off  the  factors  of 
production  when  they  become  claimants  in  distribu- 
tion. These  functions  give  the  entrepreneur  his 
strategic  position  in  industry. 

Walker  called  the  entrepreneur  the  captain  of 
industry,  and  he  was.  In  those  days,  he  was  the 
individual  Avho  controlled  industry.  But,  to-day,  we 
are  witnessing  the  passing  of  the  entrepreneur  as 
a  person;  his  functions  are  being  surrendered  to  a 
group  of  stockholders,  the  dominant  group,  and  even 
they,  in  many  cases,  are  delegating  most  of  their 
functions  to  their  hired  employees.  Yet,  the  entre- 
preneur's authority  still  exists;  he  has  the  right  to 
control  the  policy  of  his  corporation  because  he  has 
the  legal  title  to  the  capital  goods  and  to  the  product. 
Furthermore,  in  so  far  as  he  has  anything  to  do 
with  the  placing  of  labor  and  capital  in  such  a  posi- 
tion that  the  productivities  of  labor  and  of  capital 
goods  are  increased,  he  can  claim  to  be  the  creator 
of  the  increased  product.  It  will  be  shown  in  Chap- 
ter XII  that  the  entrepreneur's  only  justification  for 


46   ECONOMICS  FOR  THE  ACCOUNTANT 

claiming  profit  is  not  risk,  as  many  economists  main- 
tain, but  productivity,  and  that  if  he  is  not  really 
responsible  for  the  production  of  what  he  obtains,  he 
has  no  economic  right  to  it. 


CHAPTER  V 

THE  economist's  PROBLEM 

The  Meaning  of  "Economics." — In  Chapter  II  the 
accountant's  problems  were  discussed.  Because  it 
was  necessary  to  make  some  study  of  the  fundamen- 
tal concepts  of  economics  before  the  economist's 
problems  could  be  understood,  they  have  been  post- 
poned for  this  chapter.  It  has  been  stated  that 
economics  deals  with  men  in  their  efforts  to  satisfy 
their  w^ants.  There  are,  therefore,  two  fundamental 
problems  involved:  men  must  ** consume"  in  order 
to  satisfy  their  wants ;  men  must '  *  produce ' '  in  order 
to  obtain  the  desired  satisfactions.  For  Eobinson 
Crusoe  there  were  only  two  subdivisions  of  econ- 
omics: consumption  and  production.  He  desired  to 
consume;  therefore,  he  produced.  It  may  be  helpful 
to  the  student  to  stop  at  this  point  and  reconsider 
why  the  description  of  these  processes  is  called  * '  eco- 
nomics." If  Crusoe  had  produced  clumsily,  he 
w^ould  not  have  been  satisfying  his  wants  ' '  economi- 
cally." Economics,  therefore,  considers  the  method 
employed  and  the  amount  of  effort  expended  by  men 
in  the  satisfaction  of  their  wants.  Furthermore,  if 
Crusoe  had  eaten  too  many  fish  in  the  evening  for  his 
physical  comfort,  and  then,  had  had  none  left  for 
breakfast,  he  would  have  been  consuming  "uneco- 
nomically. ' '    An  ideal  economic  system  would  imply 

47 


48   ECONOMICS  FOR  THE  ACCOUNTANT 

the  greatest  possible  satisfaction  for  society  as  a 
whole  with  the  least  possible  effort. 

For  Crusoe  alone  there  were  no  problems  of  dis- 
tribution and  exchange,  but  if  he  and  Friday  had 
worked  together,  they  would  have  had  to  divide  the 
product  between  them.  It  has  been  shown  that  this 
division  of  the  product  would  have  been  a  very 
elementary  type  of  distribution.  In  our  modern  com- 
plex economic  organization  where  a  large  group  of 
people  cooperate  to  produce  one  commodity  and 
where  there  is  an  extensive  division  of  labor,  the 
laborers  could  not  be  paid  "in  kind"  but  must  be 
paid  in  money.  The  workers  in  a  shoe  factory  could 
not  be  given  shoes,  and,  then  be  expected  to  go  out 
and  trade  their  surplus  shoes  for  the  other  things 
they  desire.  Such  a  system  of  barter,  it  will  be 
shown  in  Chapter  VII,  would  be  uneconomical. 
Therefore,  not  only  a  more  complicated  distribution 
but  a  new  subdivision  of  economics,  exchange  or  the 
study  of  money,  distinguishes  our  present  industrial 
organization  from  the  Crusoe  system.^ 

Inasmuch  as  the  methods  of  distribution  and 
exchange  affect  the  success  with  which  laborers, 
landowners,  capitalists,  and  entrepreneurs  satisfy 
their  wants,  the  economist  has  always  given  more 
attention  to  these  two  subdivisions  than  to  produc- 
tion and  consumption.  If  the  laborers,  who  represent 
probably  95  per  cent  of  the  people,  are  not  getting 
enough  for  the  satisfaction  of  their  wants  under  the 
present  methods  of  distribution  and  exchange,  and 
if  a  few  people,  the  capitalists,  the  landowners,  and 

»See  Chapter  VII. 


THE  ECONOMIST'S  PROBLEM  49 

the  entrepreneurs,  are  receiving  far  more  than  they 
need  for  the  satisfaction  of  their  wants,  the  econ- 
omists might  be  inclined  to  criticise  the  present 
system  of  distribution  as  uneconomicah  Too  large 
a  part  of  society  would  be  doing  the  hard  work,  and 
too  small  a  part  would  be  getting  the  necessary  satis- 
faction. However,  the  economist  must  consider 
whether  the  laborer's  desires  could  be  better  satis- 
fied under  any  other  organization  of  society.  If  the 
laborers,  without  the  help  of  the  other  classes,  would 
only  produce  that  part,  or  less  than  that  part  that 
they  get  at  present,  there  might  be  some  reason  for 
saying  that  the  other  factors  earn  their  interest, 
rent,  and  profit  and  that  laborers  deserve  no  higher 
wages  than  they  get.  This  should  be  recognized  as 
an  inference  drawn  from  the  productivity  theory  of 
wages. 

In  the  past  so  much  attention  has  been  given  by 
economists  to  the  question  whether  our  present  sys- 
tem of  distribution  and  exchange  allows  the  greatest 
number  of  people  the  greatest  amount  of  satisfaction, 
that  they  have  sometimes  neglected  the  problems  of 
consumption  and  production.  Consumption,  as  will 
be  shown  in  Chapter  VI,  is  largely  a  psychological 
problem,  but  some  of  the  English  and  the  Austrian 
economists  have  stimulated  much  interest  in  it  of 
late  years.  The  problems  of  production  can  be  at- 
tacked with  more  effectiveness  by  the  accountant, 
the  engineer,  and  the  efficiency  expert  than  by  the 
economist.  When  the  economist  attempts  to  form- 
ulate principles  of  production,  he  is  handicapped  by 
the  lack  of  data.    His  pronouncements  on  the  effi- 


50   ECONOMICS  FOR  THE  ACCOUNTANT 

ciency  of  large-scale  production  ^  and  on  the  effect  of 
machinery,  for  example,  should  have  been  based  on 
inductive  studies  and  not  on  deductive  logic.  The 
accountant  and  the  technical  expert  is  probably  in  a 
better  position  than  the  economist  to  solve  many  of 
these  problems. 

The  Study  of  Prices.— It  was  explained  in  Chapter 
III  that  economics  is  sometimes  defined  as  **the 
science  that  treats  phenomena  from  the  standpoint 
of  price."  It  has  also  been  pointed  out  that  the 
study  of  prices  enables  the  economist  to  measure  the 
effectiveness  with  which  society's  wants  are  being 
satisfied.  The  consumer  must  pay  a  price  for  prac- 
tically everything  he  consumes.  The  extent  to  which 
the  consumer's  wants  are  satisfied  by  the  prices  he 
pays  is  as  much  a  psychological  as  an  economic  prob- 
lem, but  the  economist  has  a  more  direct  interest  in 
it  and,  therefore,  cannot  neglect  it.'  This  price  is 
paid  to  the  producer  and  divided  by  him  between 
the  factors  of  production,  who  are  also  claimants  in 
distribution.  The  division  of  price  by  the  producer 
between  the  different  factors  of  production  has  prob- 
ably received  more  attention  from  economists  than 
any  other  economic  problem.  Inasmuch  as  these 
factors  of  production  are  only  able  to  become  con- 
sumers  through  the  shares  they  receive  in  distribu- 
tion, the  economic  well-being  of  consumers  depends 
upon  the  fairness  of  distribution.  If  wealth  were 
distributed  so  as  to  give  but  little  satisfaction  to 
those  who  produced  much  and  too  much  satisfaction 

^See  page  157. 
"See  Chapter  VI. 


THE  ECONOMIST'S  PROBLEM  51 

to  those  who  produced  little,  such  a  system  of  dis- 
tribution would  be  uneconomic,  not  merely  because 
it  would  be  unfair,  but  also  because  it  would  prob- 
ably not  encourage  and  stimulate  productivity. 

It  will  be  shown  that  the  economist  has  three 
principal  problems  in  the  study  of  prices.  In  order 
to  explain  a  high  price,  for  example,  he  must  con- 
sider first,  the  demand  and  the  consumer;  second, 
the  supply  and  the  cost  of  the  producers,  which  is 
the  great  limitation  on  supply ;  third,  the  quantity  of 
the  medium  of  exchange,  in  terms  of  which  all  prices 
are  stated.  Chapter  VI  discusses  the  relation  of 
price  to  demand.  Chapters  VIII,  IX,  X,  XI,  and  XII 
analyze  the  relation  between  price  and  cost.  Chapter 
VII  considers  the  relation  between  price  and  the 
quantity  of  the  medium  of  exchange.  This  analysis 
of  price,  then,  will  survey  men  in  all  of  their  eco- 
nomic capacities,  in  their  efforts  (production)  to 
make  a  living  (consumption),  and  it  will  also  de- 
scribe the  mechanism  (distribution  and  exchange) 
through  which  they  are  enabled  to  satisfy  their 
wants  in  an  economic  system,  which  the  division  of 
labor  makes  so  effective  and  at  the  same  time  so 
complex. 

Practical  Economics. — As  the  world  nas  become 
more  widely  settled  and  more  thickly  populated,  as 
our  desires  have  increased  and  become  more  com- 
plex, and  as  man's  ingenuity  has  contrived  newer 
and  presumably  better  methods  of  satisfying  those 
desires,  economics  has  become  a  more  and  more  com- 
plicated science.  Agriculture,  mining,  manufactur- 
ing, and  marketing  are  not  the  only  problems  the 


52   ECONOMICS  FOR  THE  ACCOUNTANT 

economist  must  consider.  Transportation,  commer- 
cial geography,  foreign  trade,  foreign  exchange, 
banking,  insurance,  labor  problems,  and  industrial 
management  are  some  of  the  new  branches  of  applied 
economics  that  have  been  developed  within  late 
years.  There  should  be  a  particular  demand  in 
industry,  to-day,  for  specialists  in  these  branches  of 
applied  economics.  It  has  been  shown  in  Chapter  I 
that  the  first  political  economists  were  finance  minis- 
ters and  university  professors.  There  is  a  relatively 
small  demand  for  political  economists  even  to-day. 
Although  the  study  of  economics  seems  to  thrive  only 
in  the  universities,  there  is  a  great  need  in  the  gov- 
ernment for  an  understanding  of  its  principles.  The 
business  man,  however,  is  not  so  interested  in  the 
well-being  of  society  as  he  is  in  his  own  well-being. 
Although  he  may  refuse  to  consider  the  economist's 
point  of  view,  if  he  is  wise,  he  will  study  the  facts 
and  conclusions  that  the  economist  presents. 

The  above  mentioned  branches  of  applied  eco- 
nomics are  being  studied  by  many  who  contemplate 
entering  business  life.  It  has  been  shown  that  trans- 
portation is  as  much  a  process  of  production  as 
the  extractive  and  manufacturing  industries.  The 
study  of  industrial  management  is  especially  de- 
signed to  help  the  producer,  particularly  in  his 
efforts  to  increase  production,  reduce  cost,  and 
increase  profits.  Banking,  corporation  finance,  in- 
vestments, and  insurance  are  all  of  particular  inter- 
est to  the  producer  and  should  indicate  to  him  sound 
methods  of  finance  as  well  as  the  possibility  of  elimi- 
nating certain  kinds  of  risk.    Even  labor  problems 


THE  ECONOMIST'S  PROBLEM  53 

are  being  studied  for  the  benefit  of  tbe  producer 
rather  than  for  the  laborer.  Many  employers  are 
coming  to  find  it  necessary  to  understand  the  labor 
problem  in  order  to  produce  efficiently.*  It  has  been 
explained  that  the  accountant  is  working  for  the 
producer  and  has  his  point  of  view.  The  accountant, 
therefore,  is  also  interested  in  the  problems  of  pro- 
duction; in  fact,  he  is  usually  assisting  in  production. 
However,  he  has  another  interest  in  the  branches  of 
applied  economics.  He  may  be  called  upon  to  do 
work  for  a  bank,  an  insurance  company,  an  invest- 
ment banker,  or  a  railroad.  Furthermore,  in  these 
days  when  most  business  units  are  corporations,  the 
accountant  must  understand  corporation  finance  in 
order  to  do  his  work  properly. 

The  scope  of  this  book  does  not  admit  of  a  discus- 
sion of  all  of  these  branches  of  applied  economics. 
The  fundamental  principles  of  pure  economic  theory, 
however,  must  be  understood  before  the  problems  of 
applied  economics  can  be  attacked.  Special  text 
books  on  these  branches  of  applied  economics  should 
be  consulted,  although  some  of  the  fundamental 
principles  of  banking,  corporation  finance,  and 
taxation  will  be  introduced  in  the  pages  to  follow. 

*  It  i3  obvious,  however,  that  the  producer  will  become  more  in- 
terested in  a  method  of  increasing  production,  or,  better,  profit,  than 
in  a  method  of  improving  distribution.  For  this  purpose,  the  engineer 
and  the  accountant  are  more  useful  than  the  economist. 


CHAPTER  VI 

PRICE   AND  DEMAND 

Price. — It  has  been  explained  that  a  thorough- 
going analysis  of  price  would  necessarily  include  the 
whole  field  of  economics.  Wages,  interest,  rent,  and 
profit  might  be  called  the  prices  received  for  the 
services  of  laborers,  capitalists,  landowners,  and 
entrepreneurs.  But  even  when  price  is  not  used  in  so 
broad  a  sense,  but  is  limited  to  mean  the  money  value 
of  goods,  it  may  even  then  be  considered  the  central 
problem  of  economics.  Any  man  on  the  street  will 
tell  you  that  price  is  fixed  by  supply  and  demand. 
"Whether  he  has  analyzed  this  apparent  truism  is  an- 
other question.  When  the  supply  of  wheat  is  great, 
the  price  will  be  relatively  low,  but  if  the  supply  is 
small,  the  price  will  be  relatively  high.  If  the  de- 
mand for  wheat  were  to  increase,  other  things  being 
equal,  the  price  would  increase,  and  if  the  demand 
were  to  fall  off,  the  price  would  probably  decline.  It 
is  the  price  mechanism  that  adjusts  supply  and  de- 
mand. If  the  supply  of  wheat  in  one  year  is  rela- 
tively great,  the  price  falls  so  that  the  supply  is 
absorbed.  When  the  price  falls,  producers  of  wheat 
find  it  unprofitable  to  produce  this  crop  and  will 
curtail  their  production  in  the  next  period.  When 
the  production  is  curtailed,   the  demand  for  this 

54 


PRICE  AND  DEMAND  55 

staple  commodity  would  force  up  the  price  to  a  point 
at  which  the  growing  of  wheat  would  again  become 
profitable.  The  price  mechanism,  then,  might  well 
be  called  the  balance  wheel  between  demand  and 
supply. 

Inasmuch  as  the  producer  must  ultimately  pay 
the  factors  of  production  out  of  price,  it  is  usually 
assumed  that  price  should  at  least  cover  his  costs, 
which  in  Chapter  VIII  will  be  analyzed  into  the 
shares  claimed  in  distribution.  It  is  often  said  that 
the  classical  economists  laid  too  much  stress  on  the 
relation  between  price  and  cost  and  that  they  failed 
to  consider  the  other  price-determining  factors, 
which  are  to  be  discussed  in  this  chapter.  In 
Chapter  XII  it  vnl\  be  shown  that  the  price-cost  rela- 
tion is  a  fundamental  one  and  that  there  is  much  new 
to  be  said  about  it.  However,  the  other  factors  that 
affect  price  should  not  be  neglected.  The  accountant 
is  so  occupied  with  the  supply  side  of  the  equation 
that  he  often  neglects  the  demand  side.  The  sales- 
man comes  in  more  intimate  contact  with  demand 
than  any  of  the  employees  of  a  business  organiza- 
tion. On  the  supply  side,  cost  is  the  fundamental 
consideration,  because  the  greatest  limitation  on 
supply  is  cost.^  But  these  phases  of  the  problem 
will  be  discussed  in  almost  all  the  other  chapters  of 
this  book.  In  this  chapter  the  factors  other  than 
supply  and  cost  will  be  considered. 

'  The  reason  why  there  is  such  a  relatively  large  supply  of  some 
things  is  because  it  does  not  cost  much  to  produce  them,  and  the 
only  reason  why  other  things,  very  much  desired,  are  not  supplied 
in  larger  quantities  is  because  they  are  costly  to  produce.  Thus,  cost 
and  scarcity  (as  in  rare  or  art  objects)  are  the  great  limitations  on 
supply. 


56   ECONOMICS  FOR  THE  ACCOUNTANT 

The  analysis  of  demand  necessitates  a  study  of  the 
consumer  and  his  psychology.  The  consumer  is, 
after  all,  the  reason  and  the  purpose  for  all  economic 
organization.  All  of  the  accountant's  work  has  for 
its  ultimate  purpose  the  satisfaction  of  the  con- 
sumers' wants,  although  he,  like  the  producer,  does 
not  always  realize  it. 

A  good  is  a  physical  thing  that  a  consumer  de- 
sires. A  good  is  said  to  possess  *' utility"  for  the 
consumer.  Goods,  whether  they  are  free  or  eco- 
nomic, possess  utilities.  When  a  good  is  merely  use- 
ful, it  is  said  to  have  a  ** value  in  use";  but  when 
it  is  not  only  useful  but  limited  in  supply,  it  is  an 
economic  good  and  has  "value  in  exchange."  If 
water  were  a  free  good,  as  in  a  river-bank  com- 
munity, it  would  have  merely  value  in  use,  but  if  it 
were  limited  in  supply,  as  in  some  inland  city,  its 
possessor  would  be  able  to  trade  it  for  other  eco- 
nomic goods  and  it  would  have  value  in  exchange. 
It  is  important  to  note  that  some  of  the  most  vital 
necessities,  which  have  the  greatest  value  in  use,  as 
for  example,  air,  sunshine,  water,  iron,  wood,  may 
have  little  or  no  value  in  exchange;  whereas  other 
things  which  have  less  value  in  use,  as,  for  example, 
gold  and  precious  stones,  have  very  great  value  in 
exchange. 

Marginal  Utility.— If  Crusoe  on  his  desert  island 
had  been  able  to  save  no  food  except  one  box  of 
crackers  from  the  wreck,  that  unit  of  food  would 
have  had  incalculably  great  utility  for  him.  If 
soon  after  he  had  discovered  a  second  box,  each  box 
would  have  had  a  somewhat  smaller  utility.    And 


PRICE  AND  DEMAND  57 

with  the  discovery  of  subsequent  boxes,  the  utility 
of  each  box  would  have  decreased.  Even  though 
crackers  more  nearly  approach  the  staff  of  life  than 
any  other  food,  a  steady  diet  of  crackers  would 
prove  nauseating,  and  the  utility  of  fruits  and  game, 
which  he  might  have  been  able  to  procure  on  the 
island,  might  have  been  greater  than  the  inevitable 
crackers.  If  the  island  had  readily  supplied  his  food 
needs,  an  article  of  clothing  would  probably  have 
had  a  greater  utility  than  an  article  of  food.  Later, 
when  all  the  primary  necessities  of  life  were  satis- 
fied, a  book  would  have  had  a  greater  specific  utility 
for  him  than  any  unit  of  food  or  clothing,  even 
though  the  first  units  of  food  or  clothing  would  have 
been  indispensable. 

This  can  be  represented  graphically  as  in  the  fol- 
lowing diagram: 


X-  Represents  units  of  the  supply 

*j'        »  »f      n    »» satisfaction  or  utility. 


When  the  supply  is  very  small,  the  utility  of  one 
unit  becomes  indefinitely  great,  that  is,  it  approaches 
infinity;  but  as  the  supply  increases,  the  utility  de- 
creases. When  the  supply  becomes  infinite,  the 
specific  utility  of  one  unit  approaches  zero,  as  in 
free  goods.    The  curves  for  food,  for  clothing,  and 


68       ECONOMICS  FOR  THE  ACCOUNTANT 


for  books  might  be  shown  in  the  same  diagram  as 
follows: 


A -Food 
B  "  Clothing 
C  -  Books 


In  the  food  curve  A,  a  supply  so  small  as  to  ap- 
proach zero  would  have  a  utility  approaching  in- 
finity. This  would  not  be  so  true  of  the  book  curve 
C.  The  extent  to  which  the  curve  for  a  commodity 
would  approach  infinite  utility  with  a  supply  ap- 
proaching zero  might  be  used  to  furnish  a  good  basis 
for  the  distinction  between  luxuries  and  necessities. 
If  Crusoe,  after  supplying  his  food,  clothing,  and 
shelter  needs,  had  died  of  boredom  because  he  had 
no  books,  his  book  curve  should  have  been  drawn 
similar  to  the  food  curve  in  the  diagram.  For 
him,  books  would  have  been  a  necessity.  But  as 
the  book  curve  is  drawn,  books  are  assumed  to  be 
luxuries. 


PRICE  AND  DEMAND  59 

It  should  be  noted  that,  as  the  curves  are  drawn, 
it  takes  fewer  units  of  clothing,  curve  B,  than  of 
books,  curve  C,  or  units  of  food,  curve  A,  to  satisfy 
Crusoe.  Furthermore,  after  he  has  had  2x  units  of 
both  clothing  and  books,  thereafter,  each  new  book 
has  a  greater  utility  than  a  new  article  of  clothing. 
If  the  utilities  of  the  different  units  of  food  be  added, 
and  a  continuous  curve  be  assumed,  the  area  bounded 
by  the  curve  and  the  two  axes  would  represent  the 
total  utility  of  food  for  Crusoe.  Inasmuch  as  the 
first  unit  of  food  has  a  utility  approaching  infinity, 
the  area  would  be  indefinitely  great,  stretching  up 
along  the  vertical  axis.  As  new  units  are  added  the 
total  utility  is  increased,  but  only  very  slightly  when 
the  supply  becomes  great. 

Although  the  total  utility  of  clothing  is  greater 
than  the  total  utility  of  books,  after  2x  units  of  both 
are  brought  into  existence  or  consumed  the  utility 
of  the  third  unit  of  books  is  greater  than  the  utility 
of  the  third  unit  of  clothing.  This  last  unit  is  called 
the  marginal  unit,  and  its  utility  to  the  consumer  is 
called  the  marginal  utility  of  the  commodity. 

Thus,  the  marginal  utility  of  a  product  for  any 
consumer  is  the  utility  of  the  least  desired,  that  is, 
the  last  created  or  consumed,  unit  of  the  supply.  The 
seeming  paradox  that  things  that  have  little  value 
in  use  may  have  great  value  in  exchange  is  ex- 
plained by  the  marginal  utility  concept.  The  total 
utility,  determined  by  the  value  in  use,  of  food  or 
clothing  approaches  infinity,  but  their  marginal 
utilities,  which  measure  their  values  in  exchange, 


60        ECONOMICS  FOR  THE  ACCOUNTANT 

are  relatively  small  because  of  the  large  supply; 
whereas  the  total  utility  of  diamonds  is  far  less  con- 
siderable, but  their  marginal  utility  and,  conse- 
quently, their  exchange  value  is  very  great  because 
of  the  limited  supply. 

Marginal  Utility,  Cost,  and  Price. — The  value  in 
exchange  of  a  commodity,  expressed  in  monetary 
terms,  is  its  price.  The  price  that  any  consumer  will 
pay  for  a  commodity  will  be  determined  by  its 
marginal  utility  to  him.  In  making  a  choice  be- 
tween the  various  purchases  he  can  make,  their  vari- 
ous marginal  utilities  will  be  measured  by  him 
alongside  of  the  marginal  utility  of  the  money  he 
must  pay  to  get  them.  If  there  are  three  things 
equally  desired,  that  is,  with  the  same  marginal 
utility  for  him,  he  will  buy  the  cheapest  because  it 
involves  the  least  sacrifice  of  money,  but  if  the  three 
have  unequal  marginal  utilities  for  him,  he  will 
probably  select  the  one  that  has  a  marginal  utility 
most  in  excess  of  the  marginal  utility  of  the  money 
necessary  to  procure  it.  It  should  be  obvious  that 
the  judicious  consumer  will  not  make  the  exchange 
if  the  marginal  utility  of  the  commodity  to  him  is 
not  greater  than  the  marginal  utility  of  the  money 
he  must  pay  to  get  it. 

The  way  in  which  utility  affects  price  and  the  re- 
lation of  utility  and  cost  to  price  can  be  made  clear 
by  an  example.  If  the  cost  of  growing  a  peck  of  one 
vegetable  was  45  cents,  the  huckster  might  ask  50 
cents  for  it.  The  judicious  consumer  would  balance 
the  marginal  utility  of  a  peck  of  the  vegetable 
against  the  marginal  utility  of  the  50  cents  he  would 


PRICE  AND  DEMAND  61 

have  to  pay  to  get  it.  The  marginal  utility  of  50 
cents  would  depend  upon  how  much  money  he  had, 
and  upon  the  marginal  utility  to  him  of  other  vege- 
tables of  the  same  price,  or  even  of  other  foods  and 
of  other  articles.  If  he  thought  of  many  more  neces- 
sary or  more  desirable  things  he  could  purchase  for 
a  half-dollar,  he  would  probably  not  buy  the  vege- 
table, particularly  if  he  were  not  rich,  that  is,  if  the 
marginal  utility  of  money  was  large  for  him.  Other 
richer  consumers  might  buy  it,  because  for  them  its 
marginal  utility  would  be  greater  than  the  marginal 
utility  of  the  money  demanded.  Presumably  the 
price  of  this  vegetable  might  be  put  so  high  that 
only  a  few  would  purchase  it;  in  that  event,  the 
huckster  would  have  to  reduce  his  price  in  order  to 
market  all  of  his  product.  Thus,  not  only  his  cost 
but  the  marginal  utility  of  the  commodity  to  con- 
sumers collectively  would  determine  his  price  at  any 
one  time.  If  the  reduced  price  gave  him  no  profit, 
he  would  have  to  attempt  to  reduce  his  cost  or  stop 
growing  the  vegetable.  If  he  could  reduce  cost 
sufficiently,  so  as  to  be  able  to  sell  at  a  price  below 
the  marginal  utility  of  the  commodity  to  consumers, 
collectively  considered,  he  might  continue  to  produce 
at  profit.  But  if  he  could  not  reduce  cost,  he  would 
have  to  curtail  production.  The  curtailment  of  pro- 
duction would  probably  increase  the  marginal  utility 
of  the  vegetable,  because  marginal  utility  is  deter- 
mined not  only  by  the  desirability  (value  in  use)  of 
the  good  but  also  by  the  number  of  units  of  the 
supply.  Thus,  the  curtailment  of  the  supply  would 
increase  this  vegetable's  marginal  utility  and  would 


62    ECONOMICS  FOR  THE  ACCOUNTANT 

enable  the  huckster  to  ask  a  higher  price.  This 
analysis  is  merely  a  restatement  of  the  modus 
operandi  of  the  price  mechanism,  given  in  the  earlier 
part  of  this  chapter. 

These  principles  may  seem  like  mere  common 
sense,  but  their  relation  to  prices  is  often  overlooked 
by  the  accountant,  who  is  immersed  in  the  problems 
of  supply  and  cost.  The  accountant  should  be  made 
to  realize  that  cost  is  not  the  only  consideration  in 
price  making;  demand  and  the  marginal  utility  of 
the  commodity  to  the  consumer  affect  price  as  defi- 
nitely as  cost  does.  In  other  words,  price  is  the 
result  of  a  bargain,  and  it  takes  two  to  make  a  bar- 
gain. The  producer's  cost  is  no  more  important 
than  the  consumer's  marginal  utility  in  the  final 
determination  of  the  price  to  be  charged. 

Artificial  Stimulation  of  Demand. — The  foregoing 
analysis  of  the  relation  of  marginal  utility  and  price 
may  seem  to  presuppose  that  the  consumer  always 
balances  the  marginal  utilities  of  the  different  com- 
modities before  he  makes  a  purchase.  The  ignor- 
ance or  carelessness  of  consumers  in  balancing  the 
different  marginal  utilities  is  just  as  ''uneconom- 
ical" as  wasteful  or  clumsy  methods  of  production. 
One  ideal  of  economics  is  the  greatest  possible  satis- 
faction of  consumers,  and  it  is  just  as  important  as 
the  other  important  ideal,  the  production  with  the 
least  possible  effort.  Consumers  are  best  off  when 
they  derive  the  greatest  sum  of  marginal  utilities 
from  their  expenditures.  Obviously,  any  means  that 
would  educate  the  consumer  to  buy  those  things, 
which  will  have  high  marginal  utilit;y  for  him,  and 


PRICE  AND  DEMAND  63 

not  to  spend  liis  money  on  those  things  that  have 
little  or  no  marginal  utility  for  him  would  be  eco- 
nomical. Advertising  and  salesmanship  are  methods 
by  which  the  producer  attempts  to  affect  the  con- 
sumer's psychology.  If  these  selling  methods  in- 
duce the  consumer  to  buy  a  rubber  heel  rather  than 
a  leather  one,  and  if  it  can  be  assumed  that  a  rubber 
heel  will  come  to  have  a  greater  utility  for  the  con- 
sumer after  he  becomes  educated  to  it,  they  are  eco- 
nomically desirable.  In  so  far  as  advertising  is  in- 
structive, it  helps  the  consumer  to  make  more 
rational  choices.  When  a  new  commodity  with  a 
real  utility  for  the  consumer  is  introduced  by  either 
of  these  methods,  they  may  be  entirely  justified,  but 
inasmuch  as  most  advertising  and  salesmanship  are 
calculated  to  stimulate  the  producer  to  buy  a  par- 
ticular brand,  that  may  be  no  better  and  is  often 
poorer  than  some  of  the  other  brands,  and  to  buy 
that  brand  in  larger  quantities  than  its  marginal 
utility  justifies,  advertising  and  salesmanship  may 
become  interferences  with  the  free  play  of  competi- 
tion and  with  the  consumer's  greatest  possible  satis- 
faction. 


CHAPTEE  Vn 

PEICB  AND  THE  MEDIUM  OF  EXCHANGE 

The  Marginal  Utility  of  Money.— It  has  been  ex- 
plained that  the  price  the  consumer  will  pay  is  deter- 
mined not  only  by  the  marginal  utility  of  the  com- 
modity he  intends  to  buy  but  also  by  the  marginal 
utility  of  the  money  necessary  to  make  the  purchase. 
Money  has  not  the  quality  of  satisfying  the  con- 
sumer's desires  directly,  in  other  words,  it  has  no 
value  in  use  but  only  value  in  exchange.  The  con- 
sumer, before  he  parts  with  his  money,  theoretically 
considers  the  marginal  utilities  of  all  the  different 
things  that  that  particular  amount  of  money  will 
buy.  The  marginal  utility  of  a  dollar,  then,  to  any 
consumer  would  probably  be  somewhat  less  than  the 
marginal  utility  of  the  thing  purchased  with  that 
dollar.  As  the  marginal  utility  of  a  commodity  will 
vary  for  different  consumers  according  to  the  num- 
ber of  units  of  the  commodity  they  have  consumed 
or  acquired,  the  marginal  utility  of  money  will  also 
vary  according  to  the  amounts  they  have. 

If  a  poor  man  and  a  rich  man  were  equally  hungry, 
the  rich  man  would  be  able  and  willing  to  pay  much 
more  for  a  good  steak.  The  poor  man  might  offer 
one  dollar  whereas  the  rich  man  would  offer  three 
dollars.  As  it  has  been  assumed  that  the  marginal 
utility  of  the  steak  for  the  two  men  was  equal  in 

64 


PRICE  AND  MEDIUM  OF  EXCHANGE        65 

this  instance,  it  appears  that  the  marginal  utility  of 
a  dollar  was  three  times  as  great  for  the  poor  man  as 
for  his  richer  brother.  Apparently  the  more  dollars 
there  are,  the  smaller  will  be  the  marginal  utility 
of  each,  and  the  higher  will  be  prices  that  consumers 
will  pay  for  goods.  The  relation  between  the 
quantity  of  money  in  existence  and  prices  will  be 
further  explained  in  this  chapter. 

On  his  desert  island  Crusoe  produced  all  that  he 
consumed.  There  was  no  need  for  exchange  of  com- 
modities. However,  if  Crusoe  and  Friday  had 
worked  independently,  Crusoe  on  certain  things  and 
Friday  on  others,  they  might  have  exchanged  their 
products  under  some  system  of  barter.  If  they  had 
found  that  it  took  either  one  of  them  a  day  of  patient 
effort  to  catch  10  fish  and  the  same  expenditure  of 
energy  to  gather  five  boxes  of  wild  strawberries,  a 
box  of  wild  strawberries  would  probably  have  ex- 
changed for  two  fish,  provided  they  were  both 
equally  as  fond  of  the  two  products,  that  is,  that  the 
marginal  utilities  of  the  two  foods  were  equal  for 
both  of  them.  It  is  apparent  that  in  a  complicated 
social  organization,  such  as  exists  to-day,  this  system 
of  barter  would  be  impractical.  Producers  would 
not  be  able  to  estimate  with  even  a  practical  degree 
of  accuracy  the  relations  of  their  products  to  the 
many  other  kinds  of  products.  The  other  factors 
of  production  would  have  to  be  paid  in  kind  and, 
then,  would  need  to  find  others  who  would  exchange 
commodities  with  them.  The  great  difficulties  in  the 
way  of  barter  for  any  advanced  society  would  be 
too  numerous  and  too  obvious  to  consider. 


66   ECONOMICS  FOR  THE  ACCOUNTANT 

The  Standard  of  Value  and  the  Medium  of  Ex- 
change.— If  Crusoe  and  Friday,  for  the  purpose  of 
the  exchange  relation,  had  reduced  all  the  goods  and 
services,  which  they  produced,  to  a  common  stand- 
ard such  as  a  fish,  tkey  would  have  been  using  a  fish 
as  a  standard  of  value.  Then,  instead  of  innumer- 
able exchange  relations,  such  as  four  boxes  of  straw- 
berries equal  one  rabbit,  and  two  rabbits  equal  one- 
half  day's  work  on  the  hut,  and  four  boxes  of  straw- 
berries equal  eight  fish,  and  all  the  other  possible 
combinations,  there  would  be  just  one  set  of  rela- 
tions, one  box  of  strawberries  equals  two  fish;  one 
rabbit  equals  eight  fish;  one-half  day's  work  on  the 
hut  equals  16  fish.  Although  a  fish  might  be  used 
as  a  standard  of  value,  that  is,  a  commodity  that  can 
be  used  as  a  measure  for  the  value  of  other  com- 
modities, it  would  hardly  serve  as  a  medium  of  ex- 
change, that  is,  a  commodity  that  can  be  stored  or 
carried  around  to  be  given  in  exchange  for  other 
commodities.  Fish  spoil  rapidly  and  they  could  not 
be  carried  around.  The  Indians  used  wampum;  as 
a  medium  of  exchange  it  was  durable,  as  a  standard 
of  value  it  represented  to  them  a  very  desirable  com- 
modity that  embodied  great  satisfactions  in  small 
bulk.  The  most  primitive  people  seem  to  have  real- 
ized the  need  of  a  medium  of  exchange  that  was  at 
the  same  time  a  standard  of  value} 

Gold,  silver,  and  other  valuable  metals  are  used 

*A  good  standard  of  value  should  be  capable  of  being  stored  and 
held,  so  that  the  total  quantity  is  not  much  affected  by  a  new  year's 
production.  Theoretically,  this  is  true  of  gold,  and  prices  are  not 
much  affected  by  the  new  supply.  The  general  rise  in  prices  since 
1896,  however,  was  largely  due  to  increased  gold  production. 


PRICE  AND  MEDIUM  OF  EXCHANGE        67 

to-day  in  coin  by  most  of  the  civilized  nations  as  the 
standards  of  value  and  as  media  of  exchange.  They 
are  universally  desired;  they  represent  relatively 
great  value  in  small  bulk  and  thus  can  be  readily 
transported ;  they  are  durable  but  capable  of  taking 
a  permanent  impression ;  they  can  be  melted  and  re- 
divided  into  a  number  of  parts.  These  qualities  make 
them  ideal  standards  of  value  or  media  of  exchange. 

There  is  one  difficulty  involved  in  using  gold  as  a 
medium  of  exchange,  and  that  is  in  keeping  it  in  cir- 
culation. Gold  wears  oif  very  rapidly,  and  gold 
coins  are  soon  worth  less  in  metal  than  their  face 
value  would  indicate.  The  United  States  Govern- 
ment keeps  gold  and  silver  in  its  vaults  but  prints 
paper  money,  called  gold  certificates  and  silver  cer- 
tificates, for  every  dollar  in  its  possession.  These 
certificates  circulate  and  are  legal  tender,  which 
means  that  the  law  forces  creditors  to  take  them  in 
payment  of  debts.  This  paper  money  is  economical, 
because  it  saves  the  abrasion  of  the  precious  metals 
and  because  it  is  easier  to  transport.  Although  these 
certificates  have  no  value  in  use,  they  have  value  in 
exchange  because  they  are  legal  tender,  because 
there  is  gold  and  silver  behind  them,  and  because, 
even  if  there  were  no  actual  gold  and  silver  bars  in 
the  Treasury's  vaults,  the  public  has  confidence  in 
the  United  States  Government's  guarantee  of  their 
value.  The  greenbacks,  which  were  issued  by  the 
Government  with  no  deposit  of  metal  dollar  for  dol- 
lar, circulate  as  freely  as  gold  or  gold  certificates. 

Paper  Money. — There  are  other  kinds  of  paper 
money  in  circulation  than  those  described,  but  they 


68   ECONOMICS  FOR  THE  ACCOUNTANT 

are  banking  currency  and  cannot  be  understood 
without  some  knowledge  of  the  banking  system. 
Probably  the  best  way  to  understand  the  origin  of 
banks  and  banking  currency  is  to  consider  the  early 
goldsmiths  of  Amsterdam.  These  goldsmiths  not 
only  worked  on  gold  but  early  began  to  lock  it  away 
for  those  who  wanted  it  left  in  safe-keeping.  The 
goldsmith's  receipt,  given  the  owner  of  the  gold, 
might  very  well  have  been  the  oldest  kind  of  bank- 
ing currency.  If  a  reliable  goldsmith's  name  had 
become  well  known,  his  receipts  might  have  cir- 
culated almost  as  freely  as  the  gold  itself.  "Wlien 
the  goldsmith  found  that  he  could  issue  more  re- 
ceipts than  were  actually  covered  by  the  gold  in  his 
keeping,  or  the  reserve,  because  all  of  the  holders 
of  receipts  did  not  redeem  them  at  one  time,  he 
began  to  create  banking  currency,  or  credit.  This 
is  a  simplified  description  of  the  way  in  which  a 
bank  creates  banking  currency  or  bank  notes. 

The  receiving  of  deposits  and  the  issue  of  bank- 
notes is  only  one  of  the  two  principal  functions  of  a 
modern  bank.  The  other  important  function  might 
be  called  the  discount  function.  When  a  manufac- 
turer has  sold  goods  to  a  customer,  he  may  receive 
the  customer's  note  rather  than  cash.  If  the  note  is 
not  due  until  some  time  in  the  future  and  the  manu- 
facturer needs  the  money,  he  can  take  it  to  the  bank 
and  receive  the  amount  of  money  called  for  on.  its 
face  minus  a  discount,  which  is  what  the  bank  exacts 
as  a  toll  for  supplying  the  manufacturer  with  capital. 
At  the  maturity  of  the  note  the  bank  collects  its  face 
value.    Discount  then  is  another  name  for  interest. 


PRICE  AND  MEDIUM  OF  EXCHANGE        69 

A  manufacturer  can  also  borrow  from  a  bank  on 
collateral,  that  is,  on  stocks  or  bonds.  Tlie  bank 
does  not  actually  give  the  borrower  gold  or  bank 
notes  but  a  credit  on  its  books  against  which  the 
borrower  can  draw  checks.  Checks  and  bank  notes, 
then,  are  the  principal  media  of  exchange  created  by 
the  banks,  and  circulate  in  the  same  way  metallic 
coins  do.^ 

The  Quantity  Theory  of  Money. — The  quantity  of 
the  medium  of  exchange  in  existence  at  any  one  time 
is  generally  believed  to  have  a  definite  relation  to 
the  prices  of  commodities.  If  all  the  owners  of  goods 
wanted  to  sell  their  possessions  for  metallic  cur- 
rency, but  on  this  occasion  were  willing  to  part  with 
them  for  all  the  coins  in  existence,  the  prices  they 
would  receive  for  their  goods  would  be  equal  to  the 
numbers  of  dollars,  half-dollars,  quarters,  dimes, 
nickels,  and  cents  given  them.  If  the  quantity  of 
these  dollars  were  doubled,  they  would  have  re- 
ceived prices  just  twice  as  great  as  in  the  first 
example.  If  the  Indians  had  found  some  easy  me- 
chanical way  of  producing  wampum,  the  quantity  of 
this  medium  of  exchange  would  have  been  increased, 
and,  as  it  increased,  its  ratio  to  other  things  would 
have  decreased,  that  is,  other  things  would  have 
been  worth  more  units  of  wampum  or,  in  our  terms, 
would  have  increased  in  price.' 

'For  a  lucid  and  attractive  description  of  the  different  types  of 
money,  see  Hartley  Wither 's  The  Meaning  of  Money. 

*  A  more  elementary  method  of  explaining  the  quantity  theory  of 
money  may  be  helpful  for  the  beginner.  If  Friday  had  caught  10 
fish  and  had  eaten  five  of  them  and  Crusoe  had  found  five  shiny 
pebbles  and  had  his  fill  of  gazing  at  them,  they  might  have  made  an 
exchange,  had  Crusoe  wanted  the  fish  and  Friday  the  pebbles.    Then, 


70   ECONOMICS  FOR  THE  ACCOUNTANT 

Professor  Irving  Fislier's  work  on  the  quantity 
theory  of  money  is  an  attempt  to  give  a  more 
elaborate  analysis  of  these  fundamental  principles. 
His  exposition  of  this  theory  and  his  statistical 
work  on  it  can  be  found  in  his  book  entitled  The 
Purchasing  Power  of  Money  (New  York,  1911). 
Near  the  end  of  Chapter  II  of  his  book  is  the  follow- 
ing paragraph: 

In  short,  the  quantity  theory  asserts  that,  provided 
velocity  of  circulation  and  volume  of  trade  are  unchanged, 
if  we  increase  the  numher  of  dollars,  whether  by  renaming 
coins,  or  by  debasing  coins,  or  by  increasing  coinage,  or 
by  any  other  means,  prices  will  be  increased  in  the  same 
proportion.  It  is  the  number,  and  not  the  weight,  that  is 
essential.  This  fact  needs  great  emphasis.  It  is  a  fact 
which  differentiates  money  from  all  other  goods  and  ex- 
plains the  peculiar  manner  in  which  its  purchasing  power 
is  related  to  other  goods.  Sugar,  for  instance,  has  a  specific 
desirability  dependent  on  its  quantity  in  pounds.  Money 
has  no  such  quality.  The  value  of  sugar  depends  on  its 
actual  quantity.  If  the  quantity  of  sugar  is  changed  from 
1,000,000  pounds  to  1,000,000  hundred  weight,  it  does  not 
follow  that  a  hundred  weight  will  have  the  value  previously 
possessed  by  a  pound.  But  if  money  in  circulation  is 
changed  *from  1,000,000  units  of  one  weight  to  1,000,000 
units  of  another  weight,  the  value  of  each  unit  will  remain 
unchanged. 

Price  Indices. — The  quantity  theory  maintains 
that  variations  in  the  quantity  of  money  normally 
bring  about  proportional  changes  in  the  price  level, 

the  price  of  a  fish  would  probably  have  been  one  pebble.  However, 
had  Crusoe  found  ten  pebbles,  the  price  of  a  fish  would  have  been  two 
pebbles.  The  quantity  theory  states  that  prices  of  commodities  vary 
directly  with  the  quantity  of  money  used  in  exchange. 


PRICE  AND  MEDIUM  OF  EXCHANGE        71 

that  is,  prices  as  a  whole.  Thus,  inasmuch  as  the  cir- 
culating media  in  the  United  States  have  increased 
since  1890,  the  general  level  of  prices  has  increased 
proportionally.  Although  the  prices  of  some  com- 
modities may  have  risen  since  1890,  the  prices  of 
other  commodities  may  have  fallen  in  the  same 
period.  The  price  of  a  bushel  of  wheat  in  1920  may 
be  much  higher  than  it  was  in  1890,  but  the  price  of 
a  case  of  canned  goods  may  be  lower.  Some  special 
causes,  such  as  scarcity  of  farm  labor  or  improved 
methods  of  canning,  may  explain  the  particular  price 
movements  of  tliese  two  commodities.  The  quantity 
theory  of  money  assumes  that  whatever  may  be  the 
special  causes  for  price  changes  in  any  particular 
commodity,  the  prices  of  commodities  as  a  whole 
will  rise,  if  the  quantity  of  money  is  increased  and 
will  fall,  if  it  is  decreased.  Therefore,  it  early  oc- 
curred to  economists  and  statisticians  that  if  the 
average  of  a  large  number  of  prices,  including  the 
prices  of  all  the  important  commodities,  for  1890 
were  compared  with  an  average  of  the  prices  of  the 
same  commodities  for  1920,  it  would  be  possible 
to  determine  whether  prices  as  a  whole  had 
risen  in  the  period.  A  simple  average  of  the  prices 
of  a  bushel  of  wheat,  of  a  ton  of  coal,  of  a  paper 
of  pins,  and  of  a  horse  would  have  given  undue 
weight  to  the  coal  and  the  horse.  Nor  would 
this  have  been  corrected  if  the  number  of 
commodities  chosen  had  been  very  large.  However, 
if  the  prices  of  all  the  different  commodities  in  1890 
had  been  represented  by  100,  and  if  the  prices  in  the 
other  years,  for  which  comparison  were  to  be  made, 


72   ECONOMICS  FOR  THE  ACCOUNTANT 

had  been  compared  with  the  1890  prices  and  shown 
as  percentages  of  100,  the  dithculty,  growing  out  of 
the  fact  that  the  sales  units  of  the  different  com- 
modities, such  as  wheat  and  coal,  differed  in  value, 
would  have  been  eliminated.  However,  it  is  obvious 
that  this  method  would  have  given  equal  weight  to 
changes  in  the  prices  of  wheat,  of  pins,  of  coal,  and 
of  horses.  Obviously  wheat  and  coal  are  more  im- 
portant, that  is,  more  widely  used,  than  pins  or 
horses.  Therefore,  weights  had  to  be  devised  be- 
fore the  percentages  could  be  averaged.  The  weights 
used  might  be  the  total  sales  quantities  for  the  in- 
dustry as  a  whole,  of  the  commodities,  the  prices  of 
which  are  being  used.* 

If  the  prices  of  only  five  commodities  were  being 
used  to  construct  an  index  of  prices  (at  least  one 
hundred  or  two  hundred  commodities  are  needed  for 
a  reliable  index),  the  procedure  might  be  illustrated 
by  the  following  figures.  The  prices  of  the  five  com- 
modities might  have  been  as  follows: 


Com- 

Com- 

Com- 

Com- 

Com- 

modity 

modity 

modity 

morditv 

modity 

I 

II 

III 

IV 

V 

1890 

$4.00 

$.04 

$2.00 

$1.00 

$.10 

1900 

4.00 

.01 

2.50 

1.50 

.15 

1910 

5.00 

.02 

4.00 

1.00 

.20 

1920 

6.00 

.04 

4.50 

.50 

.25 

Using  the  prices  of  1890  as  a  base  (100),  the  rela- 
tive prices  tor  the  other  years  would  be  as  follows : 

*  The   weights   are   sometimes   obtained   from   the   proportional   ex- 
penditures for  the  different  commodities  in  the  family  budget. 


PRICE  AND  MEDIUM  OF  EXCHANGE        73 


Com- 

Com- 

Com- 

Com- 

Com- 

modity 

modity 

modity 

modity 

modity 

I 

II 

III 

IV 

V 

1890 

100 

100 

100 

100 

100 

1900 

100 

25 

125 

150 

150 

1910 

125 

50 

200 

100 

200 

1920 

150 

100 

225 

50 

250 

If  500,000,000,  2,000,000,000,  400,000,000,  600,- 
000,000,  4,000,000,000  represented  the  sales  in  quanti- 
ties in  bushels,  pounds,  or  quarts  of  the  five  com- 
modities in  order,  the  weights  would  have  been  as 
follows: 

Commodity     Commodity     Commodity     Commodity     Commodity 
I  II  III  IV  V 

5  20  4  6  40 

The  relative  figures  then  should  be  multiplied  by 
the  weights  and  averaged,  that  is,  the  weighted  rel- 
atives should  be  added  and  divided  by  the  sum  of  the 
weights,  75. 


1890. 


1900. 


1910. 


1920. 


Com- 

Com- 

Com- 

Com- 

Com- 

modity 

modity 

modity 

modity 

modity 

I 

II 

III 

IV 

v 

(5X100) +  (20X100) +(4X100) +(6X100) +  (40X100) 
75 

(5X100) +  (20X25) +  (4X125) +(6X150) +  (40X150) 
75 

(5X125) +  (20X50) +  (4X200) +  (6X100) +  (40X200) 
75 

(5X150)+(20X100)  +  (4X225)+(6X50)+(40X250) 
75 


=  100 


=  112 


=  147 


=  186 


74   ECONOMICS  FOR  THE  ACCOUNTANT 

Therefore,  if  1890  be  taken  as  a  base  year  (100), 
tlie  index  of  prices  in  1900  was  112,  in  1910  it  was 
147,  and  in  1920  it  was  186.  According  to  these 
figures,  there  appears  to  have  been  a  general  rise  in 
prices  since  1890,  although  in  1900  and  1910  the 
price  of  Commodity  II  fell  and  in  1910  and  1920  the 
price  of  Commidity  TV  also  showed  a  decrease. 

The  Economic  Evils  of  Changing  Price  Levels. — 
In  a  period  of  rising  prices,  the  entrepreneurs  reap 
relatively  large  profits  because  the  amounts  they 
have  to  pay  the  other  factors  of  production  are  more 
or  less  fixed,  whereas  the  prices  they  receive  are  con- 
stantly increasing.  If  laborers  are  organized  they 
can  attempt  to  keep  pace  by  demanding  increases  in 
wages  with  every  increase  in  prices,  but  the  capi- 
talist, the  bond-holder  who  lends  his  money  for  long 
periods  at  a  fixed  rate  of  interest,  and  the  unorgan- 
ized laborers  lose  what  the  entrepreneurs,  or  the 
stockholders,  gain.  The  way  in  which  an  entrepre- 
neur benefits  in  a  period  of  rising  prices  can  be 
illustrated  by  a  concrete  example.  The  unit  costs 
of  producing  a  commodity  in  two  different  months 
in  such  a  period  might  be  as  follows: 


• 

January 

Costs  per  unit 

of  product 

June 

Costs  per  unit 

of  product 

Raw  materials 

$2.00 
1.00 
1.00 
2.00 

$2.20 

Labor                    

1.10 

Interest                 

1.00 

Other  Expenses 

2.15 

$6.00 

$6.45 

PRICE  AND  MEDIUM  OF  EXCHANGE        75 

Assuming  prices  had  increased  10  per  cent  in  this 
period  as  reflected  in  increased  raw  material  costs, 
if  the  price  in  January  was  $7.00,  the  price  in  June 
would  have  been  $7.70.  Then,  the  profit  in  January 
($7.00— $6.00)  would  have  been  only  $1.00,  whereas 
in  June  it  would  have  been  ($7.70— $6.45)  or  $1.25. 
Furthermore,  if  the  manufacturer  had  produced 
goods  in  January  and  had  not  sold  them  until  June, 
the  profit  would  have  been  $1.70  on  every  unit. 
Even  if  the  laborers  had  been  well  organized  and 
had  received  an  increase  comparable  to  the  rise  in 
the  cost  of  living,  as  evidenced  by  the  rise  in  the 
price  of  this  commodity  of  10  per  cent,  the  entrepre- 
neur would  still  have  had  the  advantage  of  a  sta- 
tionary interest  rate  on  long-term  investments  and 
of  selling  goods  in  a  market  higher  than  the  market 
in  which  those  goods  had  been  produced.  If  the 
entrepreneur  borrowed  most  of  his  capital  on  short- 
term  notes  from  the  banks,  he  might  have  to  pay 
higher  interest  rates  as  prices  ascended. 

Professor  Fisher  has  proposed  stabilizing  prices 
by  keeping  the  number  of  dollars  in  circulation 
constant.  Thus,  it  is  assumed  that  rising  prices  are 
due  primarily  to  an  increased  quantity  of  the  cir- 
culating medium  and  that  if  the  rise  is  to  be  checked, 
the  quantity  of  the  medium  must  be  reduced.  If 
the  number  of  paper  dollars  bears  a  direct  relation 
to  the  number  of  gold  dollars,  and  as  the  number  of 
gold  dollars  can  be  reduced  by  increasing  the  num- 
ber of  grains  of  gold  in  a  dollar,  the  total  quantity 
of  money  can  be  regulated  at  will,  and  prices  can  be 
automatically  adjusted.    Although  it  seems  true  that 


76   ECONOMICS  FOR  THE  ACCOUNTANT 

the  most  important  factor  in  explaining  the  long- 
time fluctuations  in  the  price  level  is  the  change  in 
the  quantity  of  money,  the  quantity  of  paper  money 
is  as  important  as  the  quantity  of  gold  and  there  is 
reason  to  believe  that  the  quantity  of  paper  money 
does  not  always  bear  so  fixed  a  relation  to  the 
quantity  of  gold  as  the  quantity  theorists  have  some- 
times been  in  the  habit  of  assuming.  However,  a 
number  of  economists  have  come  to  believe  that 
some  regulation  of  the  quantity  of  money  in  circula- 
tion, whether  by  the  stabilization  of  the  dollar  or 
otherwise,  is  necessary  in  order  to  control  unneces- 
sary fluctuations  in  the  price  level. 


CHAPTER  Vin 

ECONOMIC  COST  AND  ACCOUNTING  COST 

Economic  Costs. — Cost  may  be  defined  as  the  sac- 
rifices or  expenditures  made  in  the  process  of  ob- 
taining satisfactions  or  accomplishing  ends.  Thus, 
the  costs  of  war  include  human  lives,  expenditures 
for  munitions,  as  well  as  other  sacrifices  and  losses 
that  are  harder  to  measure.  As  man's  efforts  to 
make  a  living  constitute  the  economist's  problem,  it 
is  obvious  that  the  analysis  of  these  efforts  or  costs 
is  a  large  part  of  economic  science.  To  the  positive 
efforts  spent  in  production  must  be  added  the  nega- 
tive sacrifices  in  order  to  measure  the  total  human 
costs  of  production.  These  human  costs  include  all 
the  labor,  physical  and  mental,  and  all  the  sacrifices 
expended  in  producing  goods  and  services.  It  has 
been  explained  in  the  preceding  chapter  that  the 
productive  process  requires  the  services  of  laborers 
and  probably  of  entrepreneurs  together  with  the 
sacrifices  or  postponements  of  capitalists.  All  the 
physical  exertions  with  the  attendant  fatigue  and  all 
the  mental  discomfort  expended  in  production  con- 
stitute the  human  costs  or  sacrifices.  Nothing  could 
be  produced  without  some  waste  of  energy,  fatigue, 
and  postponement  of  pleasure.  These  human  costs 
include  many  elements  that  are  difficult  or  impossi- 
ble to  measure  in  monetary  terms. 

77 


78   ECONOMICS  FOR  THE  ACCOUNTANT 

Society's  negative  as  well  as  positive  exertions 
might  be  measured  in  pain  units,  and  human  costs 
may  be  designated  sacrifice  or  pain  costs.^  If  the 
pain  or  sacrifice  units  could  be  standardized  for  all 
those  who  aid  in  production,  each  unit  might  be 
given  the  value  5.  One  laborer  might  exert  1,000 
units  of  s  in  the  same  time  and  with  the  same  effect 
that  another  laborer  would  exert  2,000  of  the  same 
units.  Thus,  1,000  s  would  be  the  sacrifice  cost  of 
the  first  laborer  whereas  2,000  s  would  represent  the 
sacrifice  cost  of  the  second  laborer  for  the  same 
quantity  of  product,  or  p.  If  it  took  x  units  of  5  to 
produce  all  commodities,  p,  then, 

xs  is  the  cost  of  p 

The  sacrifice  or  pain  cost  of  production,  xs,  could 
be  kept  stationary  or  decreased  while  the  total 
quantity  of  product,  p,  might  at  the  same  time  in- 
crease. This  could  be  accomplished  by  a  more  effec- ' 
tive  application  of  the  sacrifices  expended.  Obvi- 
ously, it  is  the  goal  of  economics  to  reduce  xs  as  much 
as  possible,  and,  in  so  far  as  more  goods  and  services 
are  needed,  it  is  desirable  to  increase  p  at  the  same 
time.  If  xs  were  expended  ineifectively,  xs  minus  ys, 
or  zs,  might  have  been  all  the  cost  necessary  to  pro- 
duce p,  where  ys  represents  all  the  pain  units  that 
were  needlessly  sacrificed,  and  where  ss  represents 
the  least  possible  cost.  The  economist  often  considers 
the  loss  due  to  the  ineffective  application  of  sacri- 
fice as  the  sacrifice  cost ;  in  terms  of  sacrifice  or  pain 

*  Where  the  capitalist  has  so  much,  the  sacrifice  in  saving  may  be 
negligible,  but  this  may  also  be  true  of  the  laborer  who  loves  hig 
work. 


ECONOMIC   AND   ACCOUNTING   COST        79 

units,  this  cost  would  be  ys.  Altliough  this  might  be 
considered  loss  or  waste,  it  does  not  constitute  the 
entire  sacrifice  cost  and  is  only  a  part  of  it.  This 
can  be  demonstrated  in  mathematical  terms  as  fol- 
lows: 

As  long  as  some  sacrifice  or  pain  will  probably 
always  be  involved  in  production,  zs,  the  least  pos- 
sible cost,  will  always  be  a  positive  quantity,  and 
xs  minus  ys  equals  zs.  Then,  xs  will  be  greater  than 
ys,  and  the  entire  sacrifice  cost  will  be  greater  than 
the  sacrifice  needlessly  expended. 

Although  the  conception  of  cost  that  has  been 
presented  is  the  concern  of  the  economist,  many  of 
the  elements  of  this  sacrifice  cost  cannot  be  measured 
accurately  in  money.  Economic  science,  inasmuch  as 
it  treats  of  a  monetary  or  price  system,  usually  at- 
tempts to  apply  the  monetary  or  numerical  measure 
to  its  concepts.  Many  sacrifice  costs  cannot  be  com- 
puted accurately  but  are  reflected,  neverthless,  in 
money  values.  The  undertaker's  possible  repulsion 
to  his  work  cannot  be  measured  by  him  in  monetary 
terms  and  should  probably  not  be  included  as  one 
of  his  costs;  however,  in  so  far  as  the  disagreeable- 
ness  of  the  work  reduces  the  number  of  competitors 
who  enter  the  field,  it  probably  increases  the  profit 
of  those  who  are  willing  to  follow  this  vocation.* 

The  concept  of  sacrifice  cost  is  sometimes  made 
even  more  embracing.  Loss  by  fire  and  the  con- 
sumption of  goods  might  be  counted  as  costs  to  be 
added  to  the  costs  involved  in  the  production  of  the 
goods  burned  or  consumed.    But  it  should  be  obvious 

*  See  page  140  where  the  relation  of  risk  to  profit  is  discussed. 


80   ECONOMICS  FOR  THE  ACCOUNTANT 

that  consumption  is  accomplishment,  the  end  of 
cost,  and  that  even  though  loss  by  fire  might  be  con- 
sidered a  social  loss,  it  could  not  be  called  a  cost  of 
production.  Depreciation,  too,  may  seem  to  be  an 
economic  cost,  but  the  analysis  of  this  item,  which 
is  to  be  given  later,  will  show  that  although  it  can  be 
reduced  to  economic  cost,  it  should  not  be  added  in 
with  the  subjective  human,  or  sacrifice,  costs  because 
such  procedure  would  involve  a  duplication,  that  is, 
adding  twice  the  human  costs  involved  in  the  pro- 
duction of  the  fixed  capital  goods  depreciated.^ 

Money  Costs. — The  economic  concept  of  cost  is 
puzzling  to  the  average  man  because  he  always 
thinks  of  cost  in  terms  of  money.  To  him,  the  cost 
of  labor  is  what  the  laborers  are  given  in  money 
wages.  He  thinks  of  wages,  interest,  rent,  profit, 
depreciation,  and  taxes,  as  the  costs  of  production. 
Marshall  would,  perhaps,  call  these  the  expenses  of 
production,  but  there  is  nothing  to  be  gained  by  this 
terminology.*  It  is  clear  that  the  sum  total  of  wages, 
interest,  rent,  and  profit  equal  the  sum  total  of  all  of 
the  prices  paid  by  all  consumers;  therefore,  the  ag- 
gregate of  these  money  shares  might  be  called  the 
consumer's  cost  of  production.  It  represents  the 
money  demanded  from  tlie  consumer  by  the  factors 
of  production;  it  is,  therefore,  the  consumer's  cost, 
or  what  he  has  to  sacrifice  to  gratify  his  desires. 
There  is  another  conception  of  consumer's  cost  that 
should  be  considered  here.  Many  economists  who 
realize  that  consumption  and  the  consumer  are  prob- 

*  See  page  110, 

•Alfred  Marshall,  Principles  of  Economics,  p.  418. 


ECONOMIC   AND   ACCOUNTING   COST        81 

ably  the  principal  interest  of  economics  believe  that 
society  and  the  consumer  is  best  served  when  prices 
are  as  low  as  possible.  However,  if  the  price  of  a 
commodity  in  any  period  were  too  far  below  costs, 
some  companies  might  fail  and  production  would 
certainly  be  curtailed.  In  that  event,  prices  might 
subsequently  rise  and  the  consumer  would  have  to 
pay  more  for  his  satisfactions  because  he  had  ob- 
tained them  at  too  low  a  price  in  the  past.  Thus, 
the  consumer's  ultimate  cost  is  not  merely  present 
price  but  an  average  of  both  present  and  future 
prices. 

Accounting  Cost  and  Entrepreneur's  Cost. — ^In  all 
that  has  been  said  about  cost,  no  mention  has  been 
made  of  cost,  as  the  accountant  defines  it.  Although 
the  accountant's  cost  is  neither  the  sacrifice 
cost  nor  the  consumer's  cost,  these  broader  con- 
ceptions must  be  grasped  before  the  accountant's 
practical  interpretation  of  them  can  be  properly 
understood.  The  accountant  is  not  keeping  books 
for  society  or  for  the  consumer;  he  keeps  his  accounts 
for  the  entrepreneur,  in  a  corporation  the  common 
stockholders,  for  whom  he  is  a  hired  laborer.^  The 
entrepreneurs  have  little  or  no  interest  in  society's 
costs  or  sacrifices ;  they  are  merely  interested  in  what 
they  have  to  expend  and  sacrifice  in  order  to  ac- 
complish their  ends,  namely,  production  and  the 
earning  of  profit.  Their  expenditures  include  the 
raw  materials  used,  the  wastage  of  fixed  capital 
goods,  what  has  to  be  paid  the  other  factors  of  pro- 

"  The  prinaipal  purposes  of  the  accountant 's  itemized  cost  were 
discussed  on  page  16  in  Chapter  II ;  they  are  set  forth  compactly, 
however,  in  Appendix  I. 


82   ECONOMICS  FOR  THE  ACCOUNTANT 

dnction,  and  what  is  taken  by  the  state.  In  this  re- 
spect, their  costs  are  identical  with  the  consumer's 
cost,  except  that  the  consumer's  expenditures  include 
the  entrepreneur 's  profit,  whereas  the  entrepreneurs 
naturally  exclude*  their  own  remuneration." 

Theoretically,  accounting  cost  should  include 
every  item  of  price  except  the  profit  claimed  by  the 
entrepreneur.  It  will  be  shown,  however,  that  some 
of  the  elements  of  price  cannot  be  included  in  ac- 
counting cost  for  practical  reasons.  Some  elements 
of  price,  which  the  entrepreneur  does  not  receive, 
such  as  the  income  tax  (page  193),  donations  (page 
190),  as  well  as  bad  debts^  and  cash  discounts  on 
sales,^  which  might  be  considered  as  elements  of 
gross  selling  price,  cannot  be  included  in  accounting 
cost.  Accounting  cost  might  he  defined  as  all  the 
entrepreneur's  necessary  expenditures  or  sacrifices 
in  production,  which  are  not  dependent  'upon  the 
consumation  of  the  sale  of  the  product.  The  full 
significance  of  this  definition  will  be  grasped  after 
reading  the  next  two  chapters,  the  discussion  of  the 
tax  on  profits  as  a  part  of  cost,  and  Appendix  11. 

Entrepreneur's  cost  is  often  thought  of  as  merely 
the  money  disbursements  that  the  entrepreneur 
makes  to  persons  other  than  himself.  The  fallacy 
in  this  idea  should  be  immediately  evident.  When 
a  person  or  group  of  persons  embodies  the  entrepre- 
neurial functions,  that  fact  does  not  preclude  the 
same  person  or  persons  from  embodying  the  function 
of  one  or  more  of  the  other  factors  of  production. 

•  See  Appendix  II. 

*  See  Appendix  II. 


ECONOMIC   AND   ACCOUNTING   COST        83 

The  classic  shoe  repairer,  who  had  accumulated  the 
capital  necessary  for  the  purchase  of  his  capital 
goods,  who  hired  no  laborer,  had  practically  no  costs 
if  money  disbursements  to  the  other  factors  of  pro- 
duction are  the  only  costs.^  The  shoe  repairer  may 
have  thought  of  his  receipts  as  all  profit,  but  careful 
analysis  would  have  shown  him  that  they  came  to 
him  not  only  as  entrepreneur,  but  also  as  capitalist- 
laborer,  and  that  they  were  for  that  reason  not  only 
profit  but  interest  on  his  invested  capital  and  wages 
for  his  labor.  If  A  embodies  the  functions  of  laborer, 
entrepreneur,  and  capitalist,  he  should  be  thought 
of  as  a  different  economic  person  in  each  capacity :  as 
entrepreneur,  he  would  be  Ai;  as  laborer,  A2;  as 
capitalist,  A3.  Then  Ai,  entrepreneur,  owes  A2  and 
A3  wages  and  interest  respectively  if  A  is  not  only 
entrepreneur  but  laborer  and  capitalist  as  well. 
Entrepreneur's  cost,  then,  is  consumer's  cost,  that 
is  price,  minus  the  profit  of  the  entrepreneur  for 
whom  the  cost  computation  is  being  made.  Just  as 
the  consumer's  costs  represent  the  consumer's  sacri- 
fices, or  payments  in  order  to  consume,  so  the  entre- 
preneur's cost  represents  his  sacrifices,  be  they  his 
money  expenditures  to  others,  his  own  work,  or  any 
other  sacrifices  he  may  make  in  his  other  economic 
capacities.  The  money  the  entrepreneur  has  to  pay 
to  others,  the  wages  that  he  owes  himself  as  laborer, 
and  the  interest  that  he  owes  himself  as  capitalist 
should  all  be  included  in  his  cost.  It  might  be  asked 
whether  the  undertaker's  repulsion  is  a  part  of  his 

•  His  raw  material  costs,  probably  included  in  overhead,  and  taxes, 
however,  vrere  actual  disbursements. 


84   ECONOMICS  FOR  THE  ACCOUNTANT 

cost.  This  repulsion  is  a  sacrifice  of  the  entrepre- 
neur, as  entrepreneur,  and  not  as  laborer  or  capi- 
talist. Whatever  he  is  paid  for  overcoming  his  re- 
pulsion is  reflected  in  a  higher  rate  of  profit. 

Most  accountants  maintain  that  the  pure  entre- 
preneur's cost  is  not  the  cost  that  they  are  attempt- 
ing to  determine.  They  note  that  the  entrepreneur 
in  most  business  organizations  usually  owns  a  part 
of  the  capital.  Therefore,  they  feel  that  they  are 
computing  a  cost  for  their  employer  as  capitalist  as 
well  as  for  their  employer  as  entrepreneur.  This 
problem  will  be  discussed  in  Chapter  X  and  in  Ap- 
pendix I.  The  entrepreneur's  cost,  which  may  or 
may  not  be  in  the  proper  conception  of  cost  for  the 
accountant,  is  the  consumer's  cost  minus  the  profit 
of  the  entrepreneur  for  whom  the  cost  computation 
is  being  made.  It  was  not  stated,  however,  that  the 
entrepreneur's  cost  is  the  consumer's  cost  minus  all 
profit  or  that  it  is  merely  wages,  rent,  and  interest. 
As  a  matter  of  fact,  any  one  entrepreneur's  cost  in- 
cludes some  profit.  Practically  every  entrepreneur 
has  to  buy  raw  materials  from  which  to  manufacture 
his  finished  product.  What  he  pays  for  this  raw 
material  is  divided  between  the  laborers,  the  land- 
owners, the  capitalists,  and  the  entrepreneur  of  the 
company  from  which  he  purchased.  Thus,  the  raw 
material  cost  of  one  entrepreneur  represents  em- 
bodied wages,  rent,  and  interest,  together  with 
profits  to  entrepreneurs,  who  were  concerned  with 
earlier  stages  of  production. 

It  might  occur  to  the  accountant  that  the  Cost  ac- 
count contains  many  items  other  than  wages,  rent, 


ECONOMIC   AND   ACCOUNTING   COST        85 

and  interest ;  in  fact,  some  might  only  identify  wages. 
It  will  be  shown  in  tlie  next  chapter,  however,  that 
all  of  the  items  of  the  Cost  account,  Kaw  Materials, 
Materials  and  Supplies,  Maintenance  and  Repairs, 
Light,  Heat,  Power,  Depreciation,  Depletion,  and  the 
other  items  of  Overhead,  can  be  analyzed  into  the 
economic  categories  already  described. 

Theoretically,  the  total  receipts  of  the  entrepre- 
neur, Sales,  representing  an  aggregate  of  prices  paid 
by  the  consumers,  are  distributed  through  him  to 
the  other  factors  of  production.  As  a  matter  of  fact, 
however,  the  entrepreneur  has  to  make  many  dis- 
bursements before  his  goods  are  sold  and  his  sales 
receipts  obtained.  This  is  made  possible  by  the  use 
of  the  capital  loaned  him  by  the  capitalist.  Thus, 
capital  not  only  enables  the  producer  to  obtain  the 
fixed  capital  goods  necessary  in  production,  but  it 
supplies  him  with  the  means  of  paying  his  costs, 
raw  materials,  interest,  rent,  and  wages,  before  he 
realizes  anything  from  the  sale  of  his  finished 
products. 


CHAPTER  IX 

THE  ELEMENTS  OF  ACCOUNTING  COST 

In  this  chapter  accounting  cost  and  the  items  that 
compose  it  will  be  considered.  If  the  accountant  is 
determining  the  cost  of  producing  a  certain  quantity 
of  flour,  which  was  manufacturred  in  a  definite 
period,  he  should  include  all  the  expenditures  and 
economic  sacrifices  of  the  flour  miller  that  went  to 
produce  that  particular  quantity  of  flour,  but  he 
should  not  include  the  entire  cost  of  the  machinery 
or  of  any  other  kind  of  capital  goods  that  were  ex- 
pected to  last  longer  than  the  stated  period  of  pro- 
duction. The  depreciation  on  these  fixed  capital 
goods,  or  that  portion  of  the  fixed  capital  goods  that 
is  used  up,  however,  is  a  part  of  his  cost.^ 

Thus,  as  was  explained  in  the  last  part  of  Chapter 
VIII,  the  accountant  conceives  of  the  capital  ob- 
tained by  the  entrepreneur  as  flowing  off  into  two 
separate  streams:  (1)  into  current  expenses  or  costs 
of  production,  such  as  wages,  interest,  rent,  and  raw 
materials;  (2)  into  fixed  investment,  such  as  build- 
ings, machinery,  land,  which  is  supposed  to  last  for 
many  production  periods. 

The  main  subdivisions  of  accounting  cost  for  a 
manufacturing  establishment,  where  cost  accounting 

» See  Chapter  X. 

86 


ELEMENTS   OF   ACCOUNTING   COST  87 

is  most  necessary,^  are  Raw  Materials,  Labor,  Fac- 
tory Overhead,  including  Rent  actually  paid,  Gen- 
eral and  Administrative  Expense,  Selling  Expense, 
and  Depreciation.  There  is  considerable  debate 
about  Interest.  The  first  two  items  are  often  called 
prime  costs,  and  theoretically  can  be  separated  so 
that  each  of  the  finished  products  can  be  made  to 
bear  the  exactly  correct  parts  of  these  items  that  are 
attributable  to  it.  The  next  two  items  are  sometimes 
grouped  together  and  called  Overhead,  but  when 
there  are  a  number  of  factories  distinct  from  the 
general  office,  this  separation  is  valuable.  The  dis- 
tinction between  prime  cost  and  overhead  lies  in  the 
fact  that  the  overhead  has  to  be  spread  over  the 
entire  product  according  to  some  estimate  and  can- 
not be  distributed  to  each  part  thereof  on  so  accurate 
a  basis.'  Selling  Expense  applies  to  the  goods  sold 
and  not  to  those  produced,  and  when  there  are  widely 
differing  inventories,  output  and  sales  will  be  very 
different.  Depreciation  on  the  capital  goods  of  the 
factory  is  often  considered  a  part  of  Factory  Over- 
head, and  depreciation  on  the  fixtures  and  furniture 
of  the  general  office  is  generally  included  in  General 
and  Administrative  Expense.  The  much  discussed 
question  regarding  Interest  as  a  cost  item  will  be 
presented  in  Chapter  X  and  Appendix  I. 

Raw  Materials. — The  first  item  in  the  manufac- 
turer's cost  is  Raw  Materials.  The  refiner  must  have 
his  crude  oil;  the  meat-packer  must  have  his  cattle; 

'See  Chapter  II,  page  15. 

•  There  is  another  important  distinction  between  prime  costs  and 
overhead   (see  page  157). 


88   ECONOMICS  FOR  THE  ACCOUNTANT 

the  tomato  canner  must  have  his  raw  tomatoes.  The 
exact  amounts  of  money  spent  for  these  raw 
materials  represent  the  Raw-Material  costs  of  the 
respective  producers.  If  the  tomatoes  had  to  be 
hauled  to  the  cannery,  the  hauling  or  collecting 
expense  might  well  be  included  in  the  Raw-Material, 
or  tomato,  cost.  If  some  of  the  tomatoes  were 
spoiled,  and  if  the  canner  were  granted  a  certain 
allowance,  the  amount  thereof  would  be  deducted 
from  his  cost.  It  has  already  been  pointed  out  in  the 
last  chapter  on  page  84  that  the  Raw-Material  cost 
represents  embodied  wages,  rent,  interest,  and  profit. 
The  canner 's  cost  of  tomatoes  represents  the  prices 
paid  therefor,  that  is,  the  wages  paid  to  farm  hands, 
the  rent  paid  to  landlords,  interest  paid  to  the  banks, 
and  profit  surrendered  the  farmer. 

A  difficulty  arises  when  the  producer  also  manu- 
factures his  raw  material.  The  refiner  quite  com- 
monly owns  the  company  that  produces  the  crude 
oil.  The  accountant  insists  that  the  refiner  include 
all  crude  oil  at  the  actual  cost  thereof  and  that  the 
crude  oil  should  not  be  transferred  from  the  produc- 
ing company  to  the  refining  company  at  market 
prices,  which  might  thereby  introduce  a  profit  to 
the  refiner  into  his  cost.*  When  the  refiner  com- 
plains that  this  procedure  would  allow  his  competi- 
tors, who  buy  their  crude  oil,  to  show  a  higher  Raw- 
Material  cost,  because  it  would  include  the  profit  on 
crude  oil  paid  the  crude  producers,  the  accountant 

*In  the  trade,  the  crude  oil  producers  are  called  "producers."  As 
a  matter  of  fact,  from  the  economic  point  of  view,  they  are  no  more 
producers  than  the  refiners  are  (see  page  20). 


ELEMENTS   OF  ACCOUNTING   COST         89 

answers  that  such  refiners  have  higher  costs.'  Their 
oil  costs  are  higher  because  their  production  unit  is 
not  so  complete.  The  refiner  who  obtains  more  capi- 
tal and  who  can  produce  his  own  crude  oil  will  have 
a  lower  cost  just  as  the  large  shoe  factory  with  a 
large  amount  of  machinery  will  probably  produce 
more  cheaply  than  the  small  shoe  factory  with  little 
machinery.  The  refiner  who  produces  his  own  crude 
oil  might  also  be  answered  by  being  told  that, 
whereas  his  competitors  have  higher  material  costs, 
he  has  a  compensation  in  a  larger  investment,  that 
is,  the  investment  in  producing  as  well  as  in  refining, 
on  which  to  calculate  interest  or  to  measure  gross 
profit — economic  interest  and  profit.  Obviously, 
the  refiner  must  realize  that  allowing  a  profit  on 
crude  oil  in  his  cost  would  be  no  different  from 
allowing  a  profit  on  the  oil,  left  after  the  gasoline 
process  had  been  completed,  in  computing  the  cost 
of  a  heavier  product,  such  as  fuel  oil.  Or,  to  take  a 
simpler  example,  the  pie  maker  who  makes  his  own 
preserves  would  not  include  a  profit  on  preserves 
when  he  was  computing  the  raw  material  cost  of  his 
pies.  All  of  the  processes  necessary  for  the  com- 
pleted pie  or  for  the  refined  petroleum  products 
should  be  treated  as  one  operation  and  no  interde- 
partmental or  intercompany  profits  should  be  al- 
lowed. 

It  might  appear  that  in  certain  extractive  and 
genetic  industries  there  is  no  Eaw-Material  cost.    A 

•  The  refiner  would  only  make  such  a  complaint  when  he  is  thinking 
of  the  Income  Tax  or  price  fixing;  a  producer  always  wants  to  have 
low  costs  even  though  he  might  not  want  them  to  appear  so. 


90   ECONOMICS  FOR  THE  ACCOUNTANT 

farmer  only  needs  to  buy  seeds,  and  for  some  crops 
it  is  conceivable  that  he  would  not  even  have  a  seed 
cost.  A  man  might  rent  a  field  merely  for  its  uncul- 
tivated field  mushrooms.  If  he  picked  them  and 
marketed  them,  he  would  be  conducting  an  economic 
organization  but  would  apparently  have  no  cost  of 
Eaw  Materials.  As  a  matter  of  fact,  he  would  prob- 
ably have  to  pay  a  higher  rent  because  of  the  mush- 
rooms. In  that  event  a  part  of  what  he  called  rent 
would  actually  have  been  Eaw-Material  cost.  The 
farmer's  Eaw-Material  cost,  for  the  same  reason, 
might  be  considered  to  include  not  only  the  cost  of 
the  seeds,  but  also  the  rent  paid  for  the  use  of  the 
soil.  The  difference  between  this  kind  of  rent  and 
pure  location  rent  will  be  explained  in  the  next  para- 
graph. 

The  Eaw-Material  cost  in  copper  mining  or  in 
crude  oil  producing  is  the  payment  made  for  the  use 
of  the  land  under  which  operations  are  being  carried 
on.  If  the  producers  have  to  purchase  a  lease,  the 
accountant  might  tell  them  to  take  the  actual  cost 
of  the  lease  and  divide  it  by  the  number  of  periods 
of  anticipated  production  in  order  to  determine  the 
Depletion  cost  for  each  period.  This  Depletion  cost 
is  similar  to  Eaw-Material  cost.  If  the  supply  is  not 
"depleted"  in  equal  proportions  in  each  year,  the 
Depletion  is  charged  in  each  period  according  to  the 
quantity  withdrawn.  Probably  the  best  method  of 
charging  Depletion  can  be  illustrated  by  an  example. 
If  a  producer  of  crude  oil  had  to  pay  $200,000  for  the 
lease  of  a  piece  of  land  that  the  geologists  estimated 
would  yield  100,000  barrels  over  a  period  of  10  years, 


ELEMENTS   OF   ACCOUNTING   COST  91 

the  Depletion  per  barrel  would  be  $2.  Then,  if 
10,000  barrels  were  ''lifted"  in  the  first  year,  the 
Depletion  charged  to  cost  would  be  $20,000,  but  if 
20,000  barrels  were  taken  out,  the  Depletion  would  be 
charged  at  $40,000.  However,  the  fact  that  the  first 
year's  flow  was  larger  than  might  have  been 
expected  may  have  resulted  in  a  revision  of  the 
estimated  number  of  barrels  in  the  deposit  to  200,- 
000  barrels ;  in  that  event  the  Depletion  per  barrel 
would  have  been  $1,  and  the  first  year's  charge 
$20,000.  The  oil  producer  often  has  to  pay  a  yearly 
rental  in  addition  to  what  he  pays  for  the  lease. 
There  are,  then,  two  kinds  of  rent:  one  kind  is  paid 
for  a  location,  that  is,  a  convenient  place  on  which 
to  produce;  the  other  kind  is  paid  for  the  actual 
properties  of  the  soil  and  is  largely  material  cost 
and  not  mere  location  rent. 

Wages. — The  second  important  item  of  the  ac- 
countant's cost  is  what  he  calls  Labor,  for  which 
wages  would  be  a  more  logical  title.  This  item  is 
often  called  Direct  Labor  and  is  supposed  to  include 
the  wages  of  the  laborers  who  work  directly  on  the 
product.  The  wages  of  the  carpenters  and  other 
laborers  who  work  in  the  plant  but  not  directly  on 
the  product  are  often  included  in  Lidirect  Labor.  The 
Factory  Superintendent's  Salary  is  not  usually  con- 
sidered a  part  of  either  item  and  is  regularly  classed 
with  Overhead.  The  sum  of  the  Direct  Labor,  the 
Indirect  Labor,  and  the  Factory  Superintendent's 
Salary  will  ordinarily  constitute  the  total  factory 
payroll. 

The  economist  takes  little  interest  in  most  of  these 


92   ECONOMICS  FOR  THE  ACCOUNTANT 

classifications;  to  him  all  those  who  work  for  a  fixe'd 
wage  or  salary,  be  they  factory  hands,  administra- 
tive clerks,  or  railroad  presidents,  are  laborers  and 
their  remunerations  are  all  called  wages.  The  econ- 
omist would  even  include  the  wage  element  in  raw 
materials  as  a  part  of  the  total  wage  distributions  of 
the  entrepreneur.  When  the  wage  earners  receive 
bonuses  depending  upon  the  entrepreneur's  profit 
or  are  actually  working  under  a  profit-sharing 
scheme,  a  part  of  their  wages  represents  a  share  of 
profits.  Although  the  wages  of  the  factory  workers 
are  classed  with  the  administrative  salaries  by  the 
economist,  the  accountant's  classification  has  some 
economic  interest.  The  factory  workers  give  their 
attention  to  ''production,"  that  is  to  supply;  the 
administrative  force  and  the  salesmen  are  very  often 
primarily  interested  in  marketing,  that  is,  demand. 
The  administrative  force  undoubtedly  gives  a  great 
deal  of  attention  to  ''production,"  in  fact  more  than 
many  accountants  seem  to  realize ;  but  the  sales  force 
is  almost  entirely  interested  in  stimulating  demand." 
It  should  be  noted  that  "production"  is  used  here  in 
the  accounting  but  not  in  the  economic  sense. 
Marketing  is  a  part  of  production,  according  to  the 
economist. 

Overhead. — Most  of  the  items  of  Overhead  can  be 
analyzed  into  labor  and  materials,  and,  therefore, 
back  into  wages,  interest,  rent,  and  profit.    This  is 

•  The  belief  that  the  administrative  force  gives  most  of  its  time  to 
Belling  rather  than  to  "production,"  in  the  accounting  sense  of  "pro- 
duction," has  led  to  the  classification  of  General  and  Administrative 
Expense  with  Selling  Expense  rather  than  with  the  manufacturing 
costs  (see  Chapter  II,  page  15). 


ELEMENTS   OF  ACCOUNTING   COST         93 

true  of  Maintenance  and  Eepairs  and  of  Materials 
and  Supplies.  Light,  Heat,  and  Power  can  be 
analyzed  into  the  same  elements  as  Raw  Materials. 
The  payments  to  the  electric  company  represent  the 
wages,  interest,  rent,  and  profit  of  the  electric  com- 
pany's Profit  and  Loss  account.  Rent,  Depreciation, 
and  Taxes,  w^hicli  are  usually  included  in  Overhead, 
will  be  discussed  in  the  next  chapter  and  in  Chapter 
XrV.  The  General  and  Administrative  Expense 
includes  one  item  of  especial  interest,  the  entre- 
preneur's salary  for  actual  services  rendered.  This 
also  will  be  discussed  in  the  next  chapter. 

It  is  clear  that  the  accountant's  classification  of 
the  items  of  cost  has  but  little  connection  with  the 
economist's  classification.  The  accountant  is  con- 
cerned with  the  way  in  which  the  entrepreneur 
spends  his  money  and  with  the  best  method  by  which 
these  expenses  can  be  allocated  to  the  different 
products  produced.  He  sometimes  even  classifies 
the  items  of  cost  by  the  processes  involved  in  manu- 
facturing the  product.  Nevertheless,  the  account- 
ant's cost  could  always  be  analyzed  into  the  econ- 
omist's categories  of  wages,  interest,  rent,  and 
profit  were  it  worth  the  trouble  and  expense. 

If  the  purposes  of  the  accountant's  cost  be  con- 
sidered, his  classification  of  items  will  be  more  under- 
standable. It  has  already  been  explained  that  the 
accountant  uses  cost  as  a  basis  of  price  and  that  he, 
therefore,  attempts  to  find  the  exact  amount  of 
expense  that  should  be  charged  to  each  unit  of 
product.^    One  of  the  accountant's  most  important 

*  See  page  16. 


94   ECONOMICS  FOR  THE  ACCOUNTANT 

problems  is  the  allocation  of  the  items  of  expense  to 
the  different  products  manufactured  when  a  num- 
ber of  products  are  produced  at  the  same  time.  The 
students  of  cost  accounting  have  devised  elaborate 
systems  for  segregating  Overhead  in  order  to  find 
the  units  costs.®  The  problems  of  expense  distribu- 
tion must  be  solved  by  the  accountant  and  the  indus- 
trial engineer,  but  there  are  certain  principles  that 
the  economist  should  announce  and  which  the  ac- 
countant must  take  heed  of,  especially  in  co-product 
and  joint-product  accounting. 

Joint  Costs. — Before  considering  these  principles, 
it  is  necessary  to  establish  arbitrarily  certain  dis- 
tinctions in  terminology.  If  two  or  more  products 
are  made  from  the  same  raw  material,  they  may  be 
called  either  joint-products  or  co-products.  Joint- 
products  may  be  defined  as  products  taken  off  at  the 
same  time.  Moreover,  one  of  the  joint-products  can- 
not be  produced  without  the  other.  Butter  and  but- 
termilk are  good  examples  of  joint-products,  be- 
cause butter  cannot  be  produced  without  the  joint- 
production  of  buttermilk.  Co-products  are  pro- 
duced from  the  same  raw  material,  but  they  are  not 
necessarily  produced  simultaneously.  Furthermore, 
only  one  of  the  co-products  must  be  produced;  the 
others  need  not  be  considered  if  there  is  no  profit 
anticipated.  For  example,  after  gasoline  is  taken 
from  crude  oil,  the  other  co-products,  kerosene,  fuel 
oil,  gas  oil,  etc.,  can  be  manufactured,  or  the  crude 
oil  remaining  after  the  extraction  of  the  gasoline 

» The  total  costs  divided  by  the  total  production  gives  the  unit  cost. 
(See  Chapter  II.) 


ELEMENTS   OF  ACCOUNTING   COST         95 

could  be  thrown  away  if  there  were  no  good  market 
for  kerosene,  fuel  oil,  and  the  other  co-products. 
Two  or  more  joint-products  might  be  main  products 
or  one  or  more  of  them  might  be  by-products,  accord- 
ing to  which  of  the  different  products  were  the  most 
important.  Thus,  if  a  butter  producer  were  little 
interested  in  buttermilk  and  merely  fed  it  to  the 
hogs,  butter  would  be  his  main  product  and  butter- 
milk merely  a  by-product.  However,  if  his  butter 
business  were  no  more  important  than  his  butter- 
milk business,  they  would  both  be  main  products.® 
For  certain  dairies,  presumably,  buttermilk  might 
be  a  main  product  and  butter  only  a  by-product.  All 
of  the  co-products  from  one  raw  material  might  be 
main  products  or  all  but  one  might  be  by-products. 
In  accounting  for  co-products,  produced  from  the 
same  raw  material  but  produced  independently, 
there  is  one  obvious  principle  to  be  considered.  Any 
method  of  cost  accounting  that  year  after  year 
results  in  a  loss  on  one  co-product  for  all  manufac- 
turers in  a  trade  should  be  suspected.  Thus,  it 
would  probably  be  erroneous  cost  accounting  to  show 
a  loss  year  after  year  on  kerosene,  if  the  trade  con- 
tinued to  produce  it.  If  a  tomato  canner  who  had 
been  throwing  away  his  cores,  skins,  and  small  fruit 
began  to  use  such  waste  for  making  pulp  and  catsup, 
he  would  not  continue  to  make  these  co-products, 
which  would  probably  also  be  by-products,  if  the 
price  received  did  not  at  least  cover  the  cost.  Labor 


•  If  buttormilk  became  the  main  product,  it  would  probably  not  be 
because  of  the  churned  buttermilk  but  rather  because  of  the  cultured 
ekim  milk. 


96   ECONOMICS  FOR  THE  ACCOUNTANT 

and  Overhead,  of  making  up  the  pulp  and  catsup.  If 
the  prices  received  just  covered  the  manufacturing 
costs,  there  would  be  no  possibility  of  allocating  a 
part  of  the  tomato,  or  Raw-Material,  cost  to  pulp  and 
catsup.  It  might  seem,  therefore,  that  the  pulp  and 
catsup  would  have  no  Raw-Material  cost.  However, 
this  would  not  necessarily  be  true.  Practically, 
there  would  be  three  different  possibilities:  (1)  if 
the  sales  realizations  from  the  co-product  did  not 
cover  the  Labor  and  Overhead  costs  specifically 
needed  in  the  manufacture  of  the  co-product,  no  part 
of  the  Raw-Material  cost  of  the  principal  co-product, 
or  main  product,  could  be  allocated  to  the  subsidiary 
co-product,  or  by-product ;  then  obviously  the  manu- 
facture of  such  a  by-product  would  be  unprofitable 
and  would  not  be  continued;  (2)  if  the  sales  realiza- 
tions from  the  co-product  just  barely  covered  the 
Labor  and  Overhead  necessary  in  the  production 
thereof,  it  would  be  impossible  to  charge  much  of  the 
Raw-Material  cost  to  such  a  co-product;  (3)  if  the 
sales  realizations  on  the  co-product  amply  covered 
its  Labor  and  Overhead  costs,  it  would  be  necessary 
to  allocate  part  of  the  Raw-Material  cost  to  the  co- 
product.  Obviously,  much  would  depend  on  what 
was  in  the  producer's  mind  when  he  purchased  the 
raw  material.  The  question  arises  as  to  the  method 
of  allocating  the  Raw-Material  cost  to  the  different 
co-products. 

If  to  the  pulp  and  catsup  there  was  allocated  no 
part  of  the  Raw-Material,  or  tomato,  cost,  and  but 
little  overhead  and  labor  were  necessary  in  the  pro- 
duction of  pulp  and  catsup,  the  pulp  would  show  a 


ELEMENTS   OF   ACCOUNTING   COST  97 

negligible  cost  and  a  large  profit.  The  accountant, 
therefore,  might  be  led  to  believe  that  the  tomato, 
or  Raw-Material,  cost  should  be  divided  between 
canned  tomatoes  and  pulp  on  the  basis  of  weight, 
that  is,  if  the  cores,  skins,  and  small  fruit  weighed 
one-eighth  as  much  as  the  fruit  that  was  canned, 
one-ninth  of  total  cost  of  the  fresh  tomatoes  should 
be  allocated  to  the  pulp  and  eight-ninths  to  the 
canned  tomatoes.  This  method  of  allocation,  which 
implies  that  a  pound  of  cores  and  skins  are  as  costly 
as  a  pound  of  the  fruit  itself,  might  consistently 
show  a  loss  on  the  pulp  and,  thus,  would  violate  the 
principle  already  announced. 

It  is  evident  that  when  the  tomato  canner  is  also 
a  pulp  manufacturer,  he  buys  two  distinct  products 
when  he  buys  his  fresh  vegetables;  he  is  buying 
tomatoes  for  canning  and  cores  and  skins  for  pulp. 
If  his  most  profitable  line  were  canned  tomatoes,  he 
would  attempt  to  buy  large  tomatoes  so  as  to  have  a 
relatively  small  waste  from  cores,  skins,  and  small 
fruit.  However,  if  pulp  or  catsup  brought  a  good 
price,  he  would  not  take  such  pains  to  avoid  a  crop 
from  which  ''waste"  of  this  kind  could  be  secured. 
Obviously,  catsup  and  pulp  might  become  main 
products,  after  having  been  by-products.  Since  such 
considerations  should,  and  must,  enter  the  manu- 
facturer's head,  it  is  evident  that  he  is  paying  two 
different  prices  for  the  two  raw  materials  and  that 
these  prices  bear  a  definite  relation  to  the  market 
values  of  the  co-products  manufactured  therefrom. 
Thus,  it  might  seem  that  if  his  total  pack  of  canned 
tomatoes  brought  four  times  as  much  as  his  pack  of 


98 


ECONOMICS  FOR  THE  ACCOUNTANT 


pulp  and  catsup,  he  should  allocate  four-fifths  of  his 
Raw-Material  cost  to  canned  tomatoes  and  one-fifth 
to  pulp.  However,  a  practical  example  will  show  the 
difficulty  involved  in  this  method  of  allocation. 

If  the  Raw-Material  cost  per  unit  for  two  co- 
products  was  $3.00  and  the  sales  realizations  from 
co-product  No.  1  was  $4.00  and  that  from  co-product 
No.  2  was  $2.00,  it  might  seem  that 


4.00 


4.00+2.00 


or  Vs 


of  $3.00,  that  is,  $2.00,  should  have  been  charged  as 
Raw-Material  cost  to  co-product  No.  1  and  Yz  of  $3.00, 
or  $1.00,  should  have  been  charged  as  Raw-Material 
cost  to  co-product  No.  2.  However,  if  it  had  cost 
$1.20  to  manufacture  co-product  No.  1  and  $1.10 
to  manufacture  co-product  No.  2,  the  Profit  and 
Loss  account  would  have  been  approximately  as 
follows : 


Co-product 
No.  1 

Co-product 
No.  2 

Sales 

$4.00 

$2.00 

Raw-Material  Cost 

$2.00 
$1.20 

$1.00 

Manufacturing  Cost 

$1.10 

Total  Cost      

$3.20 
$0.80 

$2.10 

Profit  and  Loss 

$0.10 

Thus,  this  method  of  allocation  would  have  in- 
volved a  loss  on  co-product  No.  2  because  it  would 


ELEMENTS   OF   ACCOUNTING   COST  99 

have  charged  it  with  too  much  Raw-Material  cost. 
If  this  co-product  were  a  by-product,  it  might  seem 
that  the  manufacturer  should  have  discontimied  pro- 
ducing it.  However,  if  he  had  discontinued  produc- 
ing it,  he  would  have  lost  even  more.  Although  he 
lost  $0.10  on  co-product  No.  2,  he  made  $0.80  on 
co-product  No.  1,  or  $0.70  in  all.  If  he  had  discon- 
tinued producing  co-product  No.  2,  the  following 
would  have  been  the  showing  of  his  Profit  and  Loss 
account : 

Sales,  Co-product  No .  1 $4 .  00 


Raw  Material  Cost $3 .  00 

[If  No.  2  is  not  produced,  all  has  to  be  charged  to  No.  1.] 

Manufacturing  Cost 1 .  20 

[Manufacturing  Cost  of  No.  2  has  no  longer  to  be  considered] 

Total  Cost,  Co-product  No.l $4.20 

Loss $0 .  20 

Therefore,  it  was  better  to  have  produced  co- 
product  No.  2  than  to  have  thrown  away  the  raw- 
material  left  after  co-product  No.  1  had  been  manu- 
factured. However,  the  method  of  allocation  used 
was  obviously  faulty  because  it  violated  the  principle 
announced.  As  long  as  the  sales  realizations  from 
co-product  No.  2  more  than  covered  the  manufactur- 
ing cost  of  that  co-product,  it  was  economical  to 
produce  it.  From  the  sales  the  fixed  manufacturing 
cost  might  be  deducted  and  the  Raw-Material  cost 
might  be  allocated  to  the  two  co-products  on  the 
basis  of  the  remainders,  that  is,  Raw-Material  cost 
plus  Profit. 


100      ECONOMICS  FOR  THE  ACCOUNTANT 


Co-product 
No.  1 

Co-product 
No.  2 

Sales 

S4.00 
1.20 

$2  00 

Deduct  Manufacturing  Cost 

1.10 

Remainder 

$2.80 

$0.90 

Then, 


2.80 


2.80+90 


2.80 
3^ 


=  .75 


75  per  cent  of  $3.00,  the  Raw-Material  cost,  or  $2.25, 
might  he  allocated  to  co-product  No.  1  and  $3.00 — 
$2.25  or  $0.75  to  co-product  No.  2. 


Co-product 
No.  1 

Co-product 
No.  2 

Sales 

$4.00 

$2.00 

Raw-Material  Cost 

$2.25 
1.20 

$0.75 

Manufacturing  Cost 

1.10 

Total  Cost 

$3.45 

$1.85 

Profit 

$0.55 

$0.15 

This  method  of  allocation  may  seem  to  introduce 
market  values  into  cost,  the  hete  noir  of  the  account- 
ant. However,  the  total  costs  are  included  as  costs 
with  no  element  of  profit,  and  only  the  fractions 
used  in  the  division  of  the  material  costs  between 
the  two  products  are  based  on  market  values.  The 
refiner  should  use  this  method  of  distributing  the 


ELEMENTS   OF  ACCOUNTING   COST        101 

cost  of  crude  oil  between  the  different  petroleum 
products.  Thus,  he  should  determine  the  sales  real- 
izations from  gasoline,  kerosene,  and  fuel  oil  to  be 
obtained  from  a  barrel  of  crude  oil,  and  the  method 
outlined  should  be  used  for  dividing  the  total  Raw- 
Material  cost  between  the  different  refined  products. 
This  allocation  of  material  cost  would  be  useless  if 
the  refiner  did  not  keep  an  accurate  record  of  the 
costs  of  the  processes  used  in  taking  off  the  various 
co-products. 

Accurate  records  of  the  costs  of  the  various  proc- 
esses involved  in  the  production  of  co-products,  such 
as  canned  tomatoes,  pulp  and  catsup,  or  gasoline, 
kerosene,  fuel  oil,  etc.,  may  be  possible,  but  such 
segregations  are  obviously  not  practicable  in  joint- 
product  cost  accounting.  For  example,  when  butter 
is  produced,  buttermilk  automatically  comes  into 
existence.  Even  if  it  were  reasonable  to  divide  the 
total  fresh-milk,  or  butterf at,  cost  between  the  butter 
and  the  buttermilk  merely  on  the  basis  of  the  sales 
realizations,  it  would  be  obviously  impossible  to 
determine  what  parts  of  the  total  Labor  costs  and 
Overhead  costs  should  be  allocated  to  the  two 
products  when  they  are  both  manufactured  by  the 
same  process.  The  accountant's  method  of  placing 
all  the  cost  on  the  principal  joint-product,  butter, 
and  of  deducting  the  sales  of  the  by-product,  butter- 
milk, assumes  that  all  the  buttermilk  costs,  includ- 
ing the  buttermilk  profit,  should  be  separated  from 
the  butter  costs  by  means  of  the  ratio  of  the  selling 
prices  of  the  two  products. 

The  following  example  will  show  how  the  method 


102   ECONOMICS  FOR  THE  ACCOUNTANT 

of  crediting  the  sales  of  the  by-product  practically 
corresponds  to  a  division  of  cost  between  the  main 
product  and  the  by-product  on  the  basis  of  sales. 

Assume  the  cost  of  cream  necessary  to  make  one 
pound  of  butter  were  $0.71,  and  that  on  the  basis  of 
sales  $0.70  could  be  charged  to  the  pound  of  butter 
and  $0.01  to  buttermilk.  Furthermore,  assume  that 
by  some  stretch  of  the  im.agination,  it  would  be  pos- 
sible to  separate  the  operating  costs  of  making  but- 
ter from  the  operating  costs  of  making  buttermilk; 
if  the  reader  has  no  such  imagination,  a  separation 
could  be  made  on  the  basis  of  sales.  Then,  the  costs 
might  be  as  follows: 


Costs 


Butter, 
1  pound 


Buttermilk, " 
li  pounds 


Raw  Material  (Creana) . 
Other 


Total. 


Price 

Total  Cost. 


Profit. 


$0.70 
.04 


.74 


$0.77 
.74 


.03 


.0100 
.0025 


.0125 


.0150 
.0125 


.0025 


*It  is  assumed  that  the  skim  milk  was  kept  by  the  farmer. 

Obviously  such  a  method  of  allocation  would  not 
be  possible  because  it  would  involve  a  most  uncon- 
vincing allocation  of  the  operating  costs  of  the  two 
joint-products.  Therefore,  the  accountant  places  all 
the  cost  on  the  main  product,  butter,  and  credits  the 
sale  of  the  by-product  in  the  following  way: 


ELEMENTS   OF  ACCOUNTING   COST        103 

Total  Cost  of  Raw  Material  (Butter  and  Buttermilk) $0.7100 

Total  Operating  Cost  (Butter  and  Buttermilk) 0425 

Total  Cost $0.7525 

Credit  Selling  Price  of  1^  pounds  Buttermilk 0150 

Net  Cost  of  Butter $0.7375 

It  should  be  apparent  that  whereas  in  the  first 
method  shown  the  items  of  cost  were  allocated  to  the 
two  joint-products,  in  this  method  the  crediting  of 
the  selling  price  of  the  by-product  is  really  an 
attempt  to  subtract  from  the  total  costs  the  approxi- 
mate buttermilk  costs  on  the  assumption  that  the 
buttermilk  price  will  bear  a  close  relation  to  the 
buttermilk  cost.  This  method  of  crediting  the  sale 
of  the  by-product  includes  a  profit  on  the  buttermilk 
in  the  deduction  and,  therefore,  reduces  the  butter 
cost  by  the  amount  of  such  profit.  In  the  example 
given,  the  butter  cost,  estimated  by  the  first  method, 
was  $0.74  but  estimated  by  the  second  method  it 
was  $0.7375;  the  difference  $0.0025  represents  the 
hypothetical  profit  on  the  buttermilk.  Thus,  the 
crediting  of  the  sale  of  the  by-product  in  joint- 
product  accounting  introduces  market  values  and 
profits  into  cost  in  a  way  that  might  be  considered 
far  more  objectionable  than  the  methods  suggested 
for  treating  co-products.  However,  it  is  the  only 
feasible  way  of  treating  joint-products,  and  is 
neither  illogical  nor  entirely  inaccurate. 

The  accountant  may  insist  that  crediting  the  sale 
of  the  by-product  is  based  on  the  principle  that  what- 
ever is  made  on  buttermilk  is  so  much  gained  and 
that  the  disposal  of  buttermilk  tends  to  reduce  the 


104      ECONOMICS  FOR  THE  ACCOUNTANT 

cost  of  butter.  However,  it  should  be  apparent  that 
the  selling  price  of  buttermilk  has  nothing  to  do 
with  the  cost  of  butter,  and  that  the  deduction  is 
justified  only  on  the  assumption  that  the  butter- 
milk price  will  correspond  roughly  to  the  butter- 
milk cost  and  that  its  subtraction  from  the  total  cost 
will  leave  the  actual  butter  cost. 


CHAPTER  X 

THE  DOUBTFUL  ELEMENTS  OF  ACCOUNTING  COST 

It  has  been  explained  that  practically  all  account- 
ants agree  that  certain  elements  enter  into  account- 
ing Cost  of  Sales  as  for  example,  Raw  Materials, 
Depletion,  Wages,  Rent  actually  paid,  the  miscel- 
laneous items  of  Factory  Overhead,  Depreciation, 
General  and  Administrative  Expense,  and  Selling 
Expense.  The  Income  and  Excess  Profits  Taxes  are 
usually  excluded,  although  for  some  purposes,  they 
may  be  included  in  cost.  Interest  is  usually  excluded, 
although  interest  actually  paid  or  interest  on  short- 
term  loans,  lasting  for  less  than  the  production 
period  under  consideration,  are  often  considered  cost 
items.  In  this  chapter,  the  following  items  will  be 
discussed:  Interest,  Rent,  the  entrepreneur's  salary, 
and  Depreciation.  The  treatment  of  Outward 
Freight,  of  Discount  on  Sales,  and  of  Bad  Debts  will 
be  postponed  for  Appendix  11.  The  complete  dis- 
cussion of  Interest  as  a  cost  item  will  be  given  in 
Appendix  I;  only  the  outline  of  the  theoretical 
aspects  of  the  problem  will  be  presented  in  this  chap- 
ter. The  discussion  of  taxes  in  cost  wdll  be  post- 
poned for  attention  in  Chapter  XIV  and  Appendix 
II.  This  chapter  will  be  limited  to  a  discussion  of 
the  doubtful  cost  items,  which  are  of  general  eco- 
nomic interest. 

105 


106      ECONOMICS  FOR  THE  ACCOUNTANT 

Interest  in  Cost. — The  accountant's  most  logical 
defense  for  the  exclusion  of  Interest,  whether  on 
bond^  notes,  or  on  the  entrepreneur's  own  capital, 
and  Eent,  unless  actually  paid  to  some  other  person 
than  the  producer,  might  be  based  on  the  fact  that 
he  is  not  keeping  a  cost  for  an  entrepreneur  but  for 
a  person  or  group  of  persons,  who  are  not  only  entre- 
preneur but  also  capitalist.  The  accountant  might 
maintain  that  this  producer,  or  entrepreneur — capi- 
talist, can  only  consider  as  his  costs  his  actual  dis- 
bursements to  others  Thus,  such  a  producer  could 
not  include  in  cost  an  interest  charge,  payable  to 
himself  as  capitalist.  Furthermore,  inasmuch  as  the 
accountant  refuses  to  allow  interest  on  bonds  or  on 
notes,  actually  paid  to  outside  capitalists,  it  might 
seem  that  accounting  cost  represents  the  expen- 
ditures of  the  entrepreneur  and  capitalist  combined, 
and  that  what  the  accountant  ultimately  obtains  by 
subtracting  cost  from  price  is  Gross  Profit  which  rep- 
resents a  combination  of  economic  profit  and  econ- 
omic interest.  The  accountant  would  then  seem  to  be 
making  up  his  statements  for  the  bondholders  and 
noteholders,  and  for  the  banks,  as  well  as  for  the  stock- 
holders. The  accountant  would  probably  justify  this 
combination  of  interest  and  profit  by  insisting  that 
there  is  never  a  pure  entrepreneur  and  that  the 
entrepreneur  and  capitalist  are  always  combined  in 
the  same  person  or  persons.  The  fallacy  in  this  con- 
tention and  the  misconceptions  arising  therefrom 
will  be  discussed  in  Chapter  XII  and  in  Appendix  I. 

The  accountant's  best  theoretical  reason  for  not 
finding  the  pure  entrepreneur's  cost  is  that  when  the 


DOUBTFUL  ELEMENTS  OF  ACCOUNTING  COST    107 

entrepreneur  is  also  capitalist,  liis  cost  would  have 
to  include  interest  on  his  capital.  Thus,  in  with  his 
expenditures  there  would  seem  to  be  included  a  pay- 
ment due  the  entrepreneur  himself,  although  due  him 
as  capitalist  and  not  as  entrepreneur.  Accountants 
have  argued  that  nothing  should  be  included  in  cost 
except  what  is  actually  paid  to  others  than  the 
person  or  persons  for  whom  the  cost  is  being  com- 
puted. If  the  producer,  that  is,  the  entrepreneur — 
capitalist,  can  only  consider,  as  cost  items,  disburse- 
ments to  others,  a  salary  paid  the  entrepreneur, 
when  he  works,  would  not  be  a  legitimate  part  of 
cost.  Yet,  every  accountant  allows  such  salaries  in 
Administrative  Expense.  The  inclusion  of  the  entre- 
preneur's salary  and  the  exclusion  of  interest  imply 
that  accounting  cost  is  the  sum  of  disbursements 
of  the  entrepreneur-capitalist,  plus  a  payment  to 
himself  as  laborer  if  he  works.  The  entrepreneur's 
wage  represents  his  own  sacrifice  cost;  yet  it  is 
thrown  in  with  his  actual  disbursements  to  others. 
The  inconsistency  of  excluding  interest  on  the  entre- 
preneur's investment,  because  he  pays  it  to  himself, 
and  of  including  at  the  same  time  a  salary,  paid  to 
himself,  should  be  obvious. 

The  inclusion  of  sacrifice  cost  along  with  money 
disbursements  is  not  so  illogical  as  it  may  seem.  The 
laborer's  sacrifice  cost  is  a  consideration  of  no  direct 
interest  to  the  accountant,  who  is  only  interested  in 
what  the  entrepreneur  has  to  pay,  that  is,  wages. 
Whether  the  laborer's  productivity  would  warrant 
a  higher  wage  is  no  concern  of  the  accountant.  The 
accountants,  however,  are  always  considering  the 


108   ECONOMICS  FOR  THE  ACCOUNTANT 

entrepreneur's  sacrifice  costs.  Therefore,  why 
should  they  not  include  in  costs  his  sacrifices  when 
he  works  or  when  he  employs  his  own  capital.  A 
true  entrepreneur's  cost,  then,  should  include  his 
salary  when  he  works  and  an  interest  charge  when 
he  employs  his  own  capital.  Whether  the  accountant 
should  attempt  to  find  the  entrepreneur's  cost  or  the 
entrepreneur-capitalist's  cost  is  a  problem  to  be 
further  discussed  in  Chapter  XII  and  Appendix  I. 

Rent  as  a  Cost  Item. — Accountants  allow  Rent  in 
cost  if  it  is  actually  paid,  but  if  the  producer  owns 
the  land  on  which  he  operates,  he  is  not  allowed  to 
include  an  estimated  charge.  It  must  be  evident 
from  what  was  said  on  page  23  in  Chapter  III  that, 
from  the  producer's  point  of  view,  land  is  like  any 
other  capital  goods,  and  that  when  the  entrepreneur 
discontinues  renting  and  purchases  a  piece  of  prop- 
erty, his  cost  is  no  longer  a  rental  but  the  combina- 
tion of  an  interest  charge  on  the  capital  which  mad'e 
the  purchase  possible  together  with  taxes  and  insur- 
ance. There  certainly  can  be  no  objection  to  the 
inclusion  of  Rent  in  cost,  but  it  seems  inconsistent 
to  consider  rent  actually  paid  as  a  part  of  cost  when 
interest  actually  paid  is  not  included.  The  exclusion 
of  Rent  from  cost,  however,  would  limit  the  account- 
ing conception  of  cost  still  further  and  would  make 
it  the  entrepreneur-capitalist-landowmer's  cost.  A 
true  entrepreneur's  cost  would  include  not  only  the 
rent  actually  paid  but  also  an  interest  charge  on  the 
capital  investment  plus  the  insurance  and  taxes 
actually  paid,  rather  than  an  estimated  rent  on  the 
property  owned. 


DOUBTFUL  ELEMENTS  OF  ACCOUNTING  COST    109 

One  reason,  sometimes  urged  even  by  economists, 
for  the  exclusion  from  cost  of  interest  and  rent  due 
the  entrepreneur  is  based  on  a  confusion  of  capital 
and  capital  goods.  If  a  producer  has  such  a  high 
cost  that  he  suffers  a  loss,  it  is  customary  to  say  that 
"he  earns  nothing  on  his  capital"  or  that  ''his  capi- 
tal earns  nothing. ' '  What  is  meant  is  that  his  capi- 
tal goods  earn  very  little  or  nothing.  Capital  is 
only  indirectly  productive,  that  is,  as  it  is  trans- 
ferred into  capital  goods.  As  a  matter  of  fact,  his 
laborers  may  not  have  earned  their  wages,  or  prices 
may  have  been  demoralized;  his  capital  goods,  how- 
ever, may  have  been  very  effective  and  their  specific 
productivity  may  have  more  than  covered  the  inter- 
est charge.^  Inasmuch  as  bills  and  laborers  are  paid 
first,  it  is  often  believed  that  what  is  left  is  earned 
by  the  capital  or  capital  goods.  This  is  obviously 
fallacious.  What  is  earned  by  the  capital  goods 
need  not  coincide  with  the  interest  that  is  paid  on 
capital.  The  laborer's  productivity  is  not  always 
exactly  equal  to  the  wages  he  receives.  If  a  laborer 
does  nothing  but  receive  his  wage,  his  wage  is  never- 
theless a  cost.  Thus,  even  though  the  capital  goods 
earn  nothing,  interest  is  not  necessarily  obviated. 
If  capital  is  badly  invested  so  that  the  capital  goods 
earn  very  little,  the  entrepreneur,  nevertheless,  must 
include  interest  in  cost  even  if  he  shows  a  loss. 
Whenever  laborers  fail  to  earn  their  wages  or  the 
productivity  of  capital  goods  is  less  than  the  interest 
charge,    the    entrepreneur    suffers.      Thus,    capital 

*  See  Chapter  IV. 


no   ECONOMICS  FOR  THE  ACCOUNTANT 

demands  interest  even  though  the  capital  goods  earn 
little  or  nothing. 

When  laborers  fail  to  earn  their  wages,  the  entre- 
preneur attempts  to  discharge  them  or  reduce  their 
pay.  It  must  be  conceded  that  the  entrepreneur  can- 
not immediately  dispose  of  his  capital  goods  if  they 
are  not  efficient.  When  he  has  interest  to  pay  on 
the  capital  he  borrowed  to  procure  them,  this  inter- 
est is  obviously  a  part  of  his  cost  as  long  as  he  con- 
tinues to  pay  it.  It  makes  no  difference  how  value- 
less his  plant  or  machinery  may  have  become.  If 
he  owns  the  capital  that  is  represented  by  the  capital 
goods,  the  interest  charge  is  due  him  as  capitalist. 

Depreciation  as  a  Cost  Item. — ^Although  practi- 
cally all  of  the  representative  accountants  have  come 
to  consider  Depreciation  a  cost  item,  some  manufac- 
turers have  not  yet  learned  to  include  it.  It  was 
stated  on  page  85  that  when  the  entrepreneur  owns 
capital  or  has  it  transferred  to  him,  he  uses  it  for 
two  purposes:  (1)  for  fixed  investment  that  is  sup- 
posed to  last  for  a  number  of  production  periods; 
(2)  for  use  in  what  are  called  current  costs,  such 
as  materials,  wages,  rent,  interest,  etc.  Materials 
like  machinery  and  plant  are  capital  goods  but  there 
is  one  difference  between  them;  materials  are  used  in 
one  production  period,  whereas  machinery  and  plant 
are  supposed  to  last  for  many  periods.  However,  a 
part  of  the  machinery  and  plant  are  wasted  in  each 
period;  therefore,  a  depreciation  charge  for  this 
wastage  is  included  in  each  production  period. 
Depreciation  might  be  defined  as  the  part  of  the 
fixed  capital  goods  used  up  in  production.     The 


DOUBTFUL  ELEMENTS  OF  ACCOUNTING  COST    1 1 1 

depreciation  and  the  fixed  capital  goods,  of  whicli  it 
represents  a  part,  can  be  analyzed,  just  as  materials 
are,  into  wages,  interest,  rent,  and  profit.^ 

There  is  another  question  concerning  the  inclusion 
of  Depreciation  in  accounting  cost.  Depreciation 
differs  from  the  cost  of  Eaw  Materials  in  one  impor- 
tant respect,  namely,  the  cost  of  Eaw  Materials  is 
actually  paid  to  others  whereas  the  entrepreneur, 
as  owner  of  the  capital  goods,  seems  to  be  putting  by 
Depreciation  for  himself.  But  Depreciation  is,  after 
all,  not  paid  to  him  but  to  others,  to  those  from  whom 
he  originally  purchased  his  fixed  capital  goods.  But 
they  probably  demanded  payment  in  advance  and  he 
had  to  borrow  or  use  his  own  capital  to  consummate 
the  purchase.  Therefore,  Depreciation  becomes  an 
obligation  that  he  nmst  live  up  to  in  order  to  keep 
faith  with  the  capitalist.  In  the  final  analysis,  how- 
ever. Depreciation  is  the  cost  of  that  part  of  the 
permanent  capital  goods  wasted  in  a  production 
period,  and  as  a  cost  item  should  be  classed  with 
Raw  Materials. 

Sometimes  certain  practical  objections  are  urged 
against  the  inclusion  of  Interest  in  cost.  Although 
they  will  be  discussed  in  Appendix  I,  it  seems  neces- 
sary at  this  point  to  mention  them.    It  is  said  that 

» Thus,  Depreciation  is  an  accounting:,  but  not  an  economic,  cost. 
Economic  cost  is  measured  by  the  sacrifices  made  in  carrying  on  pro- 
duction. When  capital  goods  are  produced,  the  economic  costs  are 
the  efforts  of  the  laborers,  the  sacrifices  of  the  capitalists  and  land- 
owners, and  the  skill  and  services  of  the  entrepreneur.  The  deprecia- 
tion of  the  fixed  capital  goods  represents  the  using  up  of  a  portion 
of  these  embodied  economic  costs,  but  to  count  depreciation  as  an 
economic  cost  would  merely  represent  a  duplication  of  these  embodied 
economic  costs.  They  were  counted  once  when  the  capital  goods  were 
produced,  and  should  not  be  recounted  when  the  capital  goods  are 
used  up. 


112      ECONOMICS  FOR  THE  ACCOUNTANT 

it  is  hard  to  determine  what  interest  rate  shonld  be 
allowed  on  tlie  entrepreneur's  own  capital  and  that 
it  is  often  difficult  to  determine  what  his  capital  is. 
The  method  of  determining  capital  will  be  discussed 
in  Chapter  XI  and  the  difficulties  involved  will  be 
set  forth.    It  will  be  shown  in  Appendix  I  that  the 
determination  of  the  rate  of  interest  is  not  so  difficult 
as  it  seems.    But  could  it  be  any  more  difficult  to 
determine  a  proper  interest  rate  than  to  fix  a  proper 
rate  of  depreciation?    Depreciation  is  usually  found 
by  estimating  the  probable  life  of  the  capital  goods 
that  are  being  depreciated  and  by  charging  them  off 
each  year  at  the  same  rate  until  the  accumulated 
depreciation  equals  the  original  cost  of  the  invest- 
ment.   This  method  of  determining  depreciation  is 
both  fallacious  and  inaccurate.    The  actual  amount 
wasted  should  be  charged  off,   for  instance,  if  a 
machine  was  half  worn  out  after  its  first  year,  one- 
half  should  have  been  charged  off  even  though  by 
great  care  its  lifetime  was  subsequently  prolonged. 
Furthermore,  when  the  entrepreneur  works  and  pays 
himself  a  salary,  he  estimates  his  own  worth.    There 
is  no  more  difficult  estimate  to  make  than  this  one, 
and  it  is  probably  one  of  the  least  dependable.  When 
the  entrepreneurs  want  to  hide  excessive  profits,  this 
category  is  the  usual  receptacle. 


CHAPTER  XI 

CAPITAL,    CAPITAL   GOODS,   AND  INVESTMENT 

Uses  of  Capital. — Inasmuch  as  so  many  of  tlie 
problems  tliat  have  been  presented  depend  upon  the 
definition  of  capital  and  the  distinction  between 
capital,  capital  goods,  and  investment,  it  seems  neces- 
sary to  amplify  what  has  already  been  said  about 
these  concepts  in  some  of  the  earlier  chapters.  If 
Interest  is  to  be  included  in  cost,  on  what  should 
this  Interest  be  calculated!  It  was  explained  on 
page  25  in  Chapter  III  that  capital  represents  the 
postponed  claims  of  potential  consumers  expressed 
in  terms  of  money.  After  capital  has  been  trans- 
ferred to  an  entrepreneur,  it  might  be  called  produc- 
tive capital.  It  was  stated  that  the  entrepreneur 
uses  this  productive  capital  in  order  to  obtain  fixed 
capital  goods  and  to  pay  current  expenses ;  the  capi- 
tal goods  legally  belong  to  him  and  not  to  the  capital- 
ist. The  entrepreneur,  then,  uses  capital  for  three 
different  purposes:  first,  for  fixed  investment,  such 
as  land,  buildings,  and  machinery;  second,  for 
materials  to  be  used  up  in  one  production  period; 
and  third,  for  paying  wages,  rent,  and  interest  to 
those  who  are  associated  with  him  in  production. 
Thus,  all  capital  is  not  transferred  into  capital  goods, 
such  as  fixed  investment  or  materials ;  a  part  is  used 
to  pay  wages,  rent,  interest. 

113 


114   ECONOMICS  FOR  THE  ACCOUNTANT 

If  consumers  paid  for  goods  before  they  were  pro- 
duced, rather  than  afterwards,  the  entrepreneur 
would  not  need  capital  for  capital  goods  except  for 
the  fixed  investment.  Entrepreneur 's  cost  covers  the 
entrepreneur's  entire  expenditures  for  materials 
used  up  in  the  production  period  together  with  his 
outlay  for  wages,  rent,  and  interest,  but  it  is  only 
expected  to  cover  the  depreciation  on  the  fixed 
investment  and  not  the  entire  cost  of  such  invest- 
ment. If  the  price  the  consumer  pays  covers  these 
costs,  and  if  prices  were  paid  in  advance,  the  entre- 
preneur would  have  all  the  capital  necessary  to  pay 
these  expenses,  but  he  would  not  have  enough  to 
pay  the  entire  cost  of  the  fixed  capital  goods,  as 
price  is  supposed  to  cover  only  the  depreciation 
thereon.  When  the  entrepreneur  sells  his  goods  he 
can  often  cancel  his  short  time  obligations ;  hence  he 
is  not  always  obliged  to  pay  interest  on  all  of  his 
borrowed  capital  for  the  entire  production  period. 

The  Need  for  Determining  Capital.— It  is  evident 
that  the  entrepreneur's  cost  includes  not  only  the 
wages  and  rent  paid  and  the  capital  goods  used  but 
also  the  interest  on  the  capital  out  of  which  the 
entrepreneur  makes  his  payments  and  with  which 
he  obtains  his  capital  goods.  The  determination  of 
the  amount  of  the  capital  on  which  interest  should 
be  paid  is  a  problem  of  great  importance.  It  is  often 
urged  that  the  difficulty  of  the  problem  stands  in 
the  way  of  the  inclusion  of  interest  in  cost.  But  this 
argument  has  no  value  when  it  is  remembered  that 
even  if  interest  is  not  allowed  in  cost,  the  producer 


CAPITAL  AND  INVESTMENT 


115 


usually  calculates  his  '* investment.'^  As  a  basis  on 
which  to  measure  his  return  or  for  the  determina- 
tion of  the  capital  used  for  certain  of  the  profit 
taxes,  the  calculation  of  investment  is  necessary. 
Some  cost  accountants  refuse  to  consider  the  prob- 
lem of  investment,  and  seem  to  think  that  the  cost, 
with  no  allowance  for  interest,  is  all  that  concerns 
them.  It  should  be  obvious  that  the  comparison  of 
the  costs  of  the  various  plants  of  a  company  would 
be  meaningless  if  in  some  of  those  plants  the  land 
and  buildings  were  owned  and  in  others  rented, 
because  the  accountant  allows  rent  actually  paid 
as  a  cost  item  but  he  would  not  allow  interest  on  the 
capital  invested  in  the  owned  plants.  Even  if  inter- 
est were  not  allowed  as  a  cost  item,  it  would  be 
necessary  to  have  the  investments  in  the  various 
plants  as  well  as  the  costs  for  a  comparison  of  their 
efficiencies.  Thus,  if  there  were  two  plants  operat- 
ing under  identical  conditions,  except  for  the  fact 
that  the  one  was  owned  and  the  other  rented,  the 
following  would  be  the  costs  thereof: 


Cost  per  unit 

for  Rented 

Plant  A 

Cost  per  unit 

for  Owned 

Plant  B 

Raw  Material 

$1.00 
.50 
.20 
.40 

$1  00 

Wages 

50 

Rent 

00 

Overhead,  etc 

.40 

ding  Interest  but 
actually  paid) .  .  . 

Total  Cost  (exclu 
including  Rent 

$2.10 

$1.90 

116      ECONOMICS  FOR  THE  ACCOUNTANT 

Plant  B  would  seem  to  be  lower  in  cost  than  Plant 
A,  but  this  would  not  really  be  true  because  Plant 
A  might  have  an  investment  of  $5.00  per  unit  of 
product  and  Plant  B  would  probably  have  an  invest- 
ment of  $9.00  per  unit.  Plant  B  's  larger  investment 
would  be  explained  by  the  fact  that  the  land  and 
buildings  were  owned  whereas  in  Plant  A  they  were 
merely  rented.  Then,  even  if  Interest  were  not 
included,  the  investments,  per  unit,  should  be  shown 
as  follows: 


Cost  per  unit 

and  Investment 

per  unit 

for  Plant  A 

Cost  per  imit 

and  Investment 

per  unit 

for  Plant  B 

Total  Cost 

$2.10 
5.00 

$1.90 

Investment 

9.00 

Obviously  this  method  of  presentation  would  be 
less  satisfactory  than  the  following: 


A 

B 

Cost  (minus  Interest) 

$2.10 
.25 

$1.90 

Interest  (at  5  per  cent) 

.45 

Total  Entrepreneur's  Cost 

$2.35 

$2.35 

The  Balance  Sheet. — The  Balance  Sheet  is  used  to 
determine  the  capital  or  ''investment"  on  which 
Interest  or  ''return"  is  computed.  The  following 
Balance  Sheet  represents  a  condensation  of  the  form 
shown  in  Chapter  II: 


CAPITAL  AND  INVESTMENT  117 

Assets  Liabilities 

1.  Cash  8.  Bills,    Notes,   and  Accounts 

2.  Notes  and  Accounts  Receiv-  Payable 

able  9.  Other  Current  Liabilities 

3.  Inventories  10.  Bonds  and  Mortgages 

4.  Other  Quick  Assets  11.  Preferred  Stock 

5.  Outside  Investments  12.  Common  Stock 

6.  FLxed  -\ssets  13.  Surplus 

7.  Deferred  Charges 

Inasmucli  as  capital  is  the  basis  of  interest,  the 
liability  side  of  the  balance  sheet  is  probably  the 
better  side  to  attack.  However,  the  asset  side, 
which  includes  the  capital  goods,  should  not  be 
neglected. 

If  a  business  were  assumed  to  be  starting  its  cor- 
porate life,  the  capital  obtained  through  the  sale  of 
Bonds  (10)  and  Stocks  (11  and  12)  would  probably 
be  transferred  into  the  Fixed  Assets  (6).  Some  of 
the  capital  obtained  in  this  way  might  be  used  for 
buying  materials  or  paying  current  expenses ;  in  that 
event,  a  part  of  the  permanent  capital  (10,  11,  and 
12)  would  be  represented  here  by  Inventories  and 
Cash  (1  and  3).  However,  it  might  be  better  to 
finance  the  materials  and  expenses  represented  by 
the  fluid  assets  (1  and  3)  through  short-term  notes, 
which  could  be  renewed  if  necessary.  Many  firms 
renew  short-term  notes  so  often  that  they  practically 
become  permanent  capital.  It  may  be  noticed  that 
the  Surplus  (13)  has  not  been  considered.  The  Sur- 
plus belongs  to  the  common  stockholders.  When  a 
business  begins  its  corporate  life,  there  is  probably 
no  Surplus.  However,  if  some  of  the  common  stock- 
holders had  paid  more  than  par  for  their  stock, 


118      ECONOMICS  FOR  THE  ACCOUNTANT 

there  would  be  a  Surplus  because  the  Common  Stock 
would  be  shown  at  its  par  value.^ 

The  Balance  Sheet  is  a  picture  of  the  business  at 
any  one  time.  In  order  to  get  a  true  picture  of  a 
business  for  a  year  a  Balance  Sheet  would  be  needed 
after  every  transaction.  As  production  goes  on, 
there  is  a  constant  flux  on  the  asset  side:  Raw 
Materials  are  taken  out  of  the  Inventories,  expenses 
are  paid  out  of  Cash,  the  Fixed  Assets  are  depre- 
ciated; then,  as  the  finished  products  are  sold,  the 
Cash  or  Bills  Receivable  are  increased.  While  these 
changes  in  the  various  items  are  taking  place,  the 
total  value  of  the  assets  may  not  seem  to  change. 
However,  if  the  finished  products  are  sold  for  more 
than  cost,  the  total  assets  are  increased.  In  that 
event,  there  must  be  a  corresponding  increase  on  the 
liability  side,  which  is  registered  in  Surplus.  There 
is  another  way  in  which  the  value  of  the  total  assets 
may  seem  to  be  increased  without  the  bringing  in 
of  new  capital  or  without  the  realization  of  profit  on 
sales.  If  the  capital  goods,  that  is,  the  assets, 
acquire  an  increased  market  valuation,  the  capital 
may  seem  to  increase.  The  entrepreneur,  the  stock- 
holders, would  seem  to  have  acquired  an  increment 
of  value;  if  this  increment  of  value  were  allowed  in 
an  increased  valuation  of  the  assets,  it  would  prob- 
ably be  offset  by  an  increase  in  the  Surplus.^ 


*  Thus,  if  a  company  had  sold  100,000  shares  of  common  stock  for 
$110  per  share,  the  common  stockholders  would  have  supplied  the 
business  with  $11,000,000  capital.  If  the  par  value  of  the  stock  were 
$100  per  share,  the  Common  Stock  on  the  Balance  Sheet  would  be 
$10,000,000  and  the  Surplus  $1,000,000. 

*  Unless  new  common  stock  were  issued. 


CAPITAL  AND   INVESTMENT  119 

The  Valuation  of  Capital  Goods. — ^At  tliis  point  it 
is  necessary  to  consider  the  different  reasons  wliicli 
might  explain  an  increased  valuation  of  the  capital 
goods. 

First,  capital  goods  may  seem  to  increase  in 
value  because  of  some  peculiar  outside  demand.  If 
a  manufacturer  had  been  offered  twice  his  purchase 
price  for  a  piece  of  the  land  adjacent  to  his  factory, 
he  might  have  been  tempted  to  revalue  this  piece  of 
land.  However,  if  he  did  not  actually  sell  it,  he  had 
no  right  to  revalue  it  on  the  basis  of  an  opportunity 
price.  Although  its  specific  productivity  in  his  busi- 
ness might  not  have  warranted  such  a  revaluation, 
he  might  not  have  been  able  to  part  with  it  without 
impairing  his  business.  As  an  entrepreneur,  he  had 
a  legal  claim  to  the  piece  of  land  but  his  claim  to  its 
apparently  increased  value  was  unjustified  until  he 
actually  sold  it.  It  appears,  therefore,  that  the 
entrepreneur's  claim  on  a  hypothetical  increment  of 
the  increased  value  of  the  capital  goods  is  of  a  some- 
what different  nature  from  the  capitalist's  capital, 
which  is  originally  a  claim  on  consumption  goods. 
The  entrepreneur  cannot  claim  consumption  goods 
until  he  has  actually  sold  the  capital  goods,  and  he 
cannot  claim  them  legally  until  he  has  satisfied  the 
capitalist. 

Second,  the  value  of  the  capital  goods  may  seem 
to  exceed  the  value  of  the  capital  because  of  their 
productivity.  This  may  come  about  in  one  or  two 
ways :  first,  the  entrepreneur  may  transfer  the  capital 
into  capital  goods  of  a  productivity  far  greater  than 
the  interest  he  has  to  pay;  second,  he  may  improve 


120   ECONOMICS  FOR  THE  ACCOUNTANT 

the  capital  goods,  originally  purchased,  so  that  their 
productivity  is  thereby  increased.  In  both  cases 
the  seeming  productivity  of  the  capital  goods  is 
actually  their  productivity  plus  the  productivity  of 
the  entrepreneur.  However,  the  entrepreneur  can- 
not claim  that  their  value  as  capital  goods  has 
increased  until  he  sells  them.  Their  greater  produc- 
tivity results  in  a  greater  profit  for  him;  thus,  their 
apparently  increased  value  results  in  larger  profits 
rather  than  in  a  larger  capital  valuation  and  more 
interest. 

Third,  capital  goods  may  acquire  a  greater  mone- 
tary valuation  in  a  period  of  increasing  prices.  A 
piece  of  land  purchased  for  $1,000  in  1900  might 
have  produced  10,000  units  of  product  worth  in  that 
year  $100.  To-day,  the  same  land  might  have  a 
generally  recognized  valuation  of  $2,000,  but  the 
10,000  units  of  product  would  probably  bring  $200. 
The  farmer  who  bought  his  land  30  years  ago  would 
to-day  get  twice  as  much  from  it  as  in  1890.  It 
might  seem  that  the  land  should  be  revalued  at 
$2,000.  However,  the  increased  productivity,  in 
money  terms  in  this  case,  is  all  that  the  entrepreneur 
can  consider  until  he  sells  the  land  and  receives  the 
$2,000  for  it,  and  the  increased  productivity  is  profit, 
not  interest.  When  a  business  sells  a  5  per  cent 
bond  for  $1,000,  the  bondholder,  the  capitalist,  con- 
tinues to  receive  $50  a  year  even  in  a  period  of  rising 
prices  when  the  capital  goods  may  be  earning  $100 
a  year.  The  difference,  the  other  $50,  is  profit,  not 
interest.  This  principle  may  seem  to  put  the  older 
business,  which  purchased  its  capital  goods  with  a 


CAPITAL  AND   INVESTMENT  121 

smaller  amount  of  capital,  at  a  disadvantage  when 
compared  witli  the  new  business.  However,  it 
depends  upon  the  purpose  for  which  the  capital  is 
being  determined  whether  the  principle  is  of  advan- 
tage or  disadvantage  to  the  business.  For  the  pur- 
pose of  the  Income  Tax,  a  large  capital  seems  desir- 
able; but  if  the  business  would  show  its  true  profit, 
it  should  not  revalue  its  assets. 

In  short,  when  capital  is  invested  in  capital  goods, 
they  cannot  be  considered  as  having  a  capital  value 
different  from  that  of  the  capital,  which  made  them 
possible,  until  they  are  sold  and  are  no  longer  capi- 
tal goods.  If  they  remain  capital  goods,  they  have 
no  value  except  that  derived  from  their  productivity, 
and  they  can  have  no  independent  valuation  except 
their  original  cost,  which  represents  the  invested 
capital. 

The  valuation  of  the  Balance  Sheet  items  at  orig- 
inal cost  will  give  the  original  amount  of  capital  in- 
vested, and  this  capital  is  the  only  proper  basis  for 
the  calculation  of  interest.  When  capital  goods  take 
on  an  apparent  social  valuation  in  excess  of  the  value 
of  the  capital,  the  entrepreneur  seems  automatically 
to  become  a  capitalist  and  to  have  a  claim  on  the 
increased  valuation ;  but  he  has  no  real  claim  to  any 
surplus  value  in  the  capital  goods  until  he  sells  them, 
when  he  is  no  longer  entrepreneur  but  capitalist. 
7/  it  would  he  rememhered  that  it  is  capital  and  not 
a  valuation  of  the  capital  goods  that  is  the  hasis  of 
interest,  no  difficidty  would  arise.  The  original 
cost  of  the  capital  goods,  which  might  have  been  less 
or  more  than  their  value  at  the  time  of  their  pur- 


122      ECONOMICS  FOR  THE  ACCOUNTANT 

chase,  corresponds  to  tlie  amount  of  the  capital  in- 
vested in  the  business. 

Although  no  increase  in  the  value  of  the  capital 
goods  may  be  allowed  on  the  Balance  Sheet,  it  should 
be  noted  that  even  if  the  stockholders  own  little  or 
no  capital  at  the  beginning  of  an  enterprise,  they 
become  capitalists  as  profit  is  realized.  The  entre- 
preneur who  keeps  his  profit  in  the  business  has  as 
much  right  to  consider  that  he  has  foregone  con- 
sumption as  the  capitalist.  Thus,  the  entrepreneur, 
even  if  he  did  not  supply  any  capital  at  the  inception 
of  the  business,  becomes  a  capitalist  if  he  does  not 
withdraw  his  profit.  Profits  and  interest  left  in 
the  business  represent  the  stockholders'  postponed 
claims  to  consumption  goods  and  are,  therefore, 
capital. 

Thus  far,  the  Balance  Sheet  has  been  considered 
only  for  the  purpose  of  determining  the  investment 
or  capital  on  which  interest  can  be  calculated.  It 
might  seem  that  if  the  entrepreneur  were  showing 
his  Balance  Sheet  to  the  bankers  or  if  he  were  con- 
templating selling  the  business,  he  would  want  to 
capitalize  the  earning  power.  If  the  capital  of  $1,- 
000,000  had  been  invested  20  years  ago  and  if  the 
capital  goods  to-day  have  a  market  valuation  of 
$2,000,000,  which  could  also  be  justified  by  a  Gross 
Profit,  interest  plus  profit,  of  $200,000,  the  entrepre- 
neur might  be  loath  to  have  his  Assets  valued  at  the 
original  cost  of  $1,000,000.  However,  no  business 
should  be  judged  merely  from  the  Balance  Sheet; 
the  Profit  and  Loss  accounts  for  a  series  of  years 
should  supplement  the  statement  of  Assets  and  Li  a- 


CAPITAL  AND  INVESTMENT  123 

bilities.  Obviously,  tlie  Profit  and  Loss  account 
would  show  the  skill  or  luck  of  the  entrepreneur, 
whereas  the  Balance  Sheet  should  merely  show  the 
actual  cost  of  the  capital  goods.  A  capitalization  of 
earning  power  would  be  attributing  to  the  capital 
goods  a  productivity  that  might  rightfully  be  the 
result  of  what  the  entrepreneur  actually  accom- 
plished or,  at  least,  obtained. 

The  reasons  usually  given  for  revaluing  capital 
goods  for  Balance  Sheet  purposes  might  be  sum- 
marized as  follows: 

1.  A  particular  piece  of  property  or  building  may 
take  on  an  increased  valuation  because  of  some  out- 
side demand.  However,  as  far  as  the  business,  for 
which  the  Balance  Sheet  is  made,  is  concerned,  this 
portion  of  the  capital  goods  is  no  more  valuable  after 
the  outside  demand  than  before.  If  the  high  price 
offered  does  not  cause  the  sale  of  the  property,  as  it 
may  be  indispensable  for  the  conduct  of  the  business, 
the  outside  demand  would  probably  be  met  from 
some  other  source,  and  a  few  months  later  the  par- 
ticular piece  of  property  under  consideration  might 
have  no  such  opportunity  value.  However,  if  a  piece 
of  property  continues  to  have  a  high  opportunity 
value,  but  cannot  be  sold  by  the  business  for  which 
the  Balance  Sheet  is  being  made,  this  fact  can  be  set 
forth  for  the  benefit  of  the  banks  from  which  the 
business  may  want  to  borrow.  However,  the  reval- 
uation cannot  be  justified  from  the  point  of  view  of 
the  business  unit,  that  owns  it. 

2.  A  part  or  all  of  the  capital  goods  may  become 
more  valuable  because  their  productivities  may  have 


124   ECONOMICS  FOR  THE  ACCOUNTANT 

increased  due  either  to  (a)  the  entrepreneur's,  or 
his  salaried  agents',  clever  use  of  the  capital  goods, 
or  to  (h)  the  general  rise  in  prices,  which  is  reflected 
in  higher  prices  for  capital  goods  and  for  the  prod- 
uct as  well  as  in  greater  profits.  In  both  examples, 
{a  and  h),  the  greater  productivity  is  reflected  in  a 
greater  return  on  investment,  to  use  the  account- 
ant's terminology.  This  return  is  a  combination  of 
interest  and  profit.  It  is  obvious  that  the  increased 
return  is  due  to  larger  profit  because  the  interest  is 
stationary  and  represents  a  certain  fixed  portion  of 
the  original  capital.  A  revaluation  of  the  capital 
goods  on  the  Balance  Sheet  would  seem  to  increase 
the  interest  charge  and  to  reduce  the  profit.  Thus, 
such  a  revaluation  could  be  used  to  hide  excessive 
profits,  but  it  would  be  fallacious  because  it  would 
falsify  the  basis  of  the  interest  charge.  If  business 
firms  were  to  revalue  consistently  on  the  basis  of 
productivity,  every  firm  could  fix  up  a  Balance  Sheet 
so  as  to  show  the  same  percentage  of  return,  interest 
and  profit,  as  every  other  firm. 

Goodwill. — The  problem  is  somewhat  complicated 
when  a  corporation  is  to  be  sold  to  another  cor- 
poration. In  the  next  chapter  a  type  of  incorporation 
will  be  referred  to,  the  modus  operandi  of  which 
should  be  described  here.  If  the  stockliolders  of  a 
company  had  invested  $15,000,000  in  original  capi- 
tal and  reinvested  profits  the  Balance  Sheet  might 
be  as  follows : 

Assets 

Buildings,  Machinery,  Inventories,  Cash,  etc $15,000,000 

Liabilities 
Common  Stock  and  Surplus $15,000,000 


CAPITAL  AND  INVESTMENT  125 

This  business  might  have  been  earning  about  $5,- 
000,000  in  interest  and  profit  a  year,  or  SSVs  per 
cent  on  the  invested  capital.  The  stockholders  would 
hardly  have  been  satisfied  to  take  $15,000,000  in  cash 
for  this  business,  which  represented  a  $15,000,000 
investment  and  which  was  earning  33>^  per  cent 
thereof.  In  many  instances  the  stockholders  sell 
their  business  to  a  newly  created  corporation,  for  an 
issue  of  $15,000,000  worth  of  seven  per  cent  preferred 
stock  and  $40,000,000  worth  of  common  stock.  Then 
the  new  corporation's  Balance  Sheet  might  be  as 
follows : 

Assets 

Buildings,   Machinery,  Inventories  Cash,  etc $15,000,000 

Goodwill 40,000,000 

Liabilities 

Seven  per  cent  Preferred  Stock $15,000,000 

Common  Stock 40,000,000 

The  ''Goodwill"  would  be  considered  justified  by 
the  productivity  or  earning  power  of  the  corpora- 
tion. After  the  seven  per  cent  dividends  on  the  pre- 
ferred were  paid,  there  would  still  be  $3,950,000  or 
$5,000,000  minus  $1,050,000,  left  for  the  common 
stock,  that  is  9.8  per  cent.  The  original  stockholders 
of  the  first  corporation,  then,  would  sell  the  pre- 
ferred stock  but  they  would  probably  hold  the  com- 
mon stock.  Those  who  bought  the  preferred  stock 
in  the  market  would  be  supplying  the  capital,  or 
rather  they  w^ould  be  allowing  the  original  stock- 
holders to  withdraw  their  $15,000,000  investment. 
The  preferred  stockholders  would  then  represent  the 
outside  capitalists  and  the  original  common  stock- 
holders,   who    had    been    entrepreneur-capitalists, 


126   ECONOMICS  FOR  THE  ACCOUNTANT 

would  now  be  pure  entrepreneur,  as  owners  of  the 
$40,000,000  common  stock,  which  represented  no 
investment. 

The  capital  invested  in  the  second  corporation 
would  be  $15,000,000,  no  different  from  that  invested 
in  the  first;  yet,  the  assets  of  the  second  company- 
would  show  $40,000,000  Goodwill,  in  addition  to  the 
$15,000,000  original  cost  of  the  capital  goods.  If 
Goodwill  is  shown  clearly  on  the  Balance  Sheet, 
there  is  no  harm  done.  However,  the  accountant 
should  realize  that  when  he  is  computing  the  capital 
invested,  he  should  add  the  common  and  preferred 
stocks  to  the  bonds  and  other  interest-bearing  lia- 
bilities hut  he  should  deduct  the  Goodwill  on  the 
asset  side.  It  is  far  easier  to  deal  with  this  kind  of 
reappraisal  than  with  the  revaluations  of  specific 
capital  goods,  which  are  not  so  easily  detected. 

When  a  corporation  spends  money  perfecting  a 
patent  or  in  developing  a  trade-name  through  adver- 
tising or  otherwise,  this  investment  is  often  used  to 
justify  the  '  *  Goodwill ' '  on  the  Balance  Sheet.  Thus, 
the  expenditure  of  a  few  thousand  dollars  is  often 
considered  justification  for  a  Goodmll  item  of  mil- 
lions. The  Balance  Sheet  should  show  the  actual 
amount  of  capital  so  expended,  as  it  is  a  legitimate 
addition  to  investment,  but  the  amount  of  Goodwill 
added  as  a  result  of  the  earning  power  should  be 
shown  separately  so  that  it  will  not  be  included  in 
the  invested  capital. 

If  the  holders  of  the  $40,000,000  of  common  stock 
afterwards  sold  a  quarter  of  their  holdings  to  out- 
side capitalists,  and  the  $10,000,000  of  capital  sur- 


CAPITAL  AND  INVESTMENT  127 

rendered  were  invested  in  the  corporation,  some  of 
the  Goodwill  might  be  squeezed  out,  provided  the 
controlling  stockholders  did  not  demand  notes  for 
the  $10,000,000  of  their  capital."  Then  the  Balance 
Sheet  would  be  as  follows : 

Assets  Liabilities 

Old  Assets $15,000,000  Preferred  Stock $15,000,000 

New  Assets 10,000,000  Common  Stock 40,000,000 

Goodwill 30,000,000 

Short-Term  Notes.— If  $1,000,000  of  capital  had 
been  secured  by  the  sale  of  bonds  and  stocks,  and  if 
$100,000  had  been  borrowed  from  the  banks  at  five 
per  cent  for  the  three  months  March  to  May,  the 
actual  interest  paid  on  the  note  is  considered  by  some 
accountants  to  be  a  part  of  cost.  Then,  if  cost  were 
$4,000,000,  excluding  all  interest,  the  total  cost  would 
be  $4,005,000  and  the  investment  $1,000,000.  The 
second  possible  way  of  treating  these  figures  would 
be  to  consider  the  cost  $4,000,000  and  the  investment 
$1,025,000,  as  already  explained  in  the  foregoing 
paragraphs.  The  inclusion  of  interest  in  cost  would 
obviate  the  difiiculties  of  both  methods.  If  there  had 
been  a  $400,000  six  per  cent  bond  issue,  and  if  the 
stock  had  been  sold  when  the  interest  rate  for  long- 
term  investments  of  the  same  amount  of  risk  was  five 
per  cent,  a  total  interest  charge  of  $59,000  ($5,000 
on  the  three-months '  note,  $24,000  on  the  bonds,  and 
$30,000  on  the  stockholders'  investments)  could  have 
been  added  to  the  cost,  $4,000,000,  and  the  problem  of 
investment  would  have  been  obviated. 

The  accountant  uses  the  term  'investment"  in- 

*  This  would  be  unusual  but  not  improbable. 


128      ECONOMICS  FOR  THE  ACCOUNTANT 

stead  of  ''capital."  He  says,  for  example,  ''a  pro- 
ducer should  have  a  return  on  his  investment "  or ''  in- 
terest on  investment  should  not  be  included  in  cost. ' ' 
He  sometimes  means  by  "investment"  that  part  of 
the  capital  used  through  the  entire  year,  that  is,  the 
capital  represented  by  the  fixed  capital  goods,  such 
as  lands,  buildings,  and  permanent  machines.  That 
part  of  capital  that  goes  into  materials,  wages,  rent, 
and  interest  may  be  neglected  by  him  if  these  ex- 
penses are  financed  through  short-term  notes,  that  is, 
notes  running  for  less  than  a  year.  Some  accountants 
include  interest  on  short-term  notes  in  cost  and 
thereby  dispose  of  them.  Those  who  believe  in  the 
pure  entrepreneur's  cost  and  who  consider  interest  a 
cost  item  will  feel  that  this  is  a  step  in  the  right 
direction  but  they  will  have  to  admit  that  it  is  not 
consistent  with  the  exclusion  of  other  interest  from 
cost.  If  the  accountant  insists  upon  a  consistent  en- 
trepreneur-capitalist's cost,  short-term  notes  would 
have  to  be  included  in  the  capital  or  investment 
along  with  the  bonds.  However,  inasmuch  as  they 
would  not  run  through  the  entire  production  period, 
an  adjustment  would  have  to  be  made.  Thus,  if  a 
company  borrowed  $40,000  at  six  per  cent  for  three 
months,  the  loan  might  be  considered  identical  with 
a  year's  note  for  $10,000  at  about  the  same  rate  of 
interest. 

The  Basis  of  the  Interest  Charge.— If  Interest  is  to 
be  treated  as  a  cost  item,  it  should  be  apparent  that 
from  no  one  Balance  Sheet  can  the  capital  used 
during  a  production  period  be  determined.  The  short 
term  notes  may  have  been  borrowed  in  March  and 


CAPITAL  AND  INVESTMENT  129 

paid  off  by  November ;  thus,  no  evidence  of  their  ex- 
istence could  be  found  on  the  Balance  Sheets  at  the 
beginning  or  at  the  end  of  the  year.  There  is  another 
reason  why  neither  the  first  nor  the  last  of  the 
Balance  Sheets  will  give  the  capital  invested 
accurately.  The  first  and  last  Balance  Sheets  differ 
ordinarily  only  by  the  amount  of  profit  earned  on  the 
sale  of  goods.*  If  the  business  is  a  corporation,  this 
profit  is  really  the  interest  and  profit  of  the  stock- 
holders. The  profit  is  usually  earned  in  varying 
amounts  all  through  the  year.  Thus,  some  parts  of 
the  total  profit  of  a  year  would  be  in  the  business 
for  almost  12  months,  whereas  some  parts  would  be 
earned  in  December  and  would  be  capital  for  less 
than  a  month.  Unless  some  special  condition  existed 
one-half  of  the  total  profit  could  be  considered  the 
average  reinvested  profit  to  be  added  to  the  capital. 
In  order  to  determine  the  interest  that  should  be 
added  to  cost,  the  Balance  Sheets  at  the  beginning 
and  at  the  end  of  the  year,  together  with  a  record  of 
interest  actually  paid  on  short-term  notes  running 
for  less  than  a  year  would  be  necessary.  The  interest 
on  short-term  notes  and  on  bonds  and  the  so-called 
dividends  on  the  preferred  stocks  could  be  added  to 
cost,  and  no  estimates  would  be  necessary.  Then, 
assuming  that  the  capital  goods,  the  assets,  were 
valued  at  original  cost,  the  stockholders'  capital 
could  be  determined  from  the  first  Balance  Sheet, 
and  the  profit  earned  and  interest  accrued  for  the 
stockholders  could  be  determined  from  the  last. 


*  New  capital  or  tho  sale  of  tho  capital  goods,  assets,  mi{:;ht  explain 
a  larger  capital  on  the  last  Balance  Sheet  than  on  the  first. 


130   ECONOMICS  FOR  THE  ACCOUNTANT 

It  should  be  apparent  that  the  interest  rate  to  be 
charged  on  the  stockholders'  capital  should  be  the 
interest  rate  prevailing  for  that  kind  of  investment 
at  the  time  the  capital  was  invested,  and  that  the 
rate  to  be  charged  on  the  profit  and  interest  earned 
during  the  year  should  be  at  the  rates  prevailing  at 
the  time  the  profits  and  the  interest  were  realized. 
Obviously,  when  a  bondholder  invests  his  money  in 
five  per  cent  bonds,  he  must  always  expect  a  five  per 
cent  return,  no  matter  how  the  interest  rate  may 
change  subsequently.  When  the  stockholder  invests 
his  capital,  he  should  have  thereafter  the  interest 
rate  for  long-term  investments  prevailing  at  the  time 
he  invested. 

The  Bills  Payable,  which  bear  no  interest,  should 
be  separated  from  the  Notes  Payable  and  should  not 
be  considered  a  part  of  the  corporation's  capital. 
These  bills  represent  the  capital  of  other  entrepre- 
neurs, but  the  entrepreneur  for  whom  the  capital  is 
being  determined  does  not  have  to  pay  interest  on 
them,  and,  therefore,  should  not  include  them  in  his 
capital. 

A  summary  of  the  steps  to  be  taken  in  order  to 
determine  the  interest  charge  and  the  basis  on  which 
estimated  interest  should  be  charged  may  be  given 
as  follows : 

The  dividends  on  the  preferred  stock,  assuming 
that  the  preferred  stock  is  of  the  kind  already 
described,  should  be  added  to  the  interest  on  the 
bonds  and  short-term  notes,  that  is,  on  all  interest- 
bearing  paper,  and  this  total  of  interest  paid  or 
payable  should  be  added  to  cost. 


CAPITAL  AND  INVESTMENT  131 

The  Balance  Sheet  as  of  January  1  and  of  De- 
cember 31  should  be  obtained  with  all  the  assets 
valued  at  original  cost  plus  the  improvements 
represented  by  actual  capital  investment. 

Then,  from  the  Common  Stock  and  Surplus,  the 
Goodwill  on  the  asset  side  should  be  deducted,  if  any 
Goodwill  not  represented  by  actual  investment  is 
included. 

The  remainder  will  represent  the  common  stock- 
holder's capital  on  wliich  interest  will  have  to  be 
estimated.  If  the  common  stock  was  all  sold  when 
the  company  was  incorporated,  the  accurate  amount 
of  capital  represented  by  the  original  investment 
will  be  available.  Then,  this  amount  should  be 
multiplied  by  the  interest  rate  prevailing  for  invest- 
ments of  this  kind  at  the  time  of  incorporation  of 
the  company. 

The  profits  and  interest  earned  in  former  years, 
that  were  left  in  the  business,  mil  be  shown  in  the 
Surplus  of  the  first  Balance  Sheet.  If  the  rate  of 
interest  changed  materially  during  the  years  be- 
tween incorporation  and  the  date  of  the  first  Balance 
Sheet  for  the  year  under  consideration,  some  allow- 
ance will  have  to  be  made  for  the  rate  to  be  charged 
on  the  accumulated  undivided  profits,  that  is,  the 
Surplus. 

The  profits,  or  dividends,  earned  during  the  year 
under  consideration  will  have  to  be  considered  as 
well  as  those  earned  in  former  years.  It  has  been 
suggested  that  the  year's  profit,  which  usually  is  the 
difference  between  the  Surplus  of  January  1,  and 
that    of    December    31,    should  be  cut  in  half  and 


132      ECONOMICS  FOR  THE  ACCOUNTANT 

multiplied  by  the  rate  prevailing  during  the  year 
unless  monthly  Profit  and  Loss  accounts  can  be  used 
to  determine  this  figure  more  accurately. 

There  is  one  item  on  the  asset  side  the  valuation 
of  which  is  much  disputed.  It  has  been  explained 
that  all  the  capital  goods  used  in  the  Kusiness  should 
be  valued  at  cost,  since  this  valuation  represents 
the  capital  invested.  The  inventories  of  manu- 
factured goods,  which  are  capital  goods  on  the  asset 
side,  should  accordingly  be  valued  at  their  cost  of 
production  and  all  the  inventories  of  raw  materials 
should  be  valued  at  the  prices  paid  for  them. 
Although  accountants  attempt  to  value  inventories 
at  cost  both  on  the  Profit  and  Loss  account  and  on 
the  Balance  Sheet,  they  usually  value  them  at  the 
market  price  if  market  price  is  below  cost.  This 
procedure  is  followed  because  of  its  safety;  the 
accountant  believes  that  although  it  may  have  cost 
$1.00  to  produce  a  certain  commodity,  if  its  market 
value  is  $0.80  it  would  be  dangerous  to  allow  the 
stockholders  to  think  that  they  have  an  asset  worth 
25  per  cent  more  than  its  market  value.  The  reader 
who  has  given  consideration  to  this  chapter  should 
realize  that  the  stockholder  should  never  believe  that 
the  Balance  Sheet  tells  the  worth  of  his  business  at 
any  time.  If  Inventories  are  to  be  revalued,  why  not 
the  fixed  assets?  If  the  fixed  assets  cost  $1,000,000, 
they  are  so  valued  on  the  Balance  Sheet,  even  though 
their  true  market  value  at  the  time  of  their  purchase 
or  subsequently  might  have  been  as  small  as  $400,000. 
Obviously,  if  the  Balance  Sheet  is  to  be  used  to  show 
the  invested  capital.  Inventories  must  be  valued  at 


CAPITAL  AND  INVESTMENT  133 

cost  whatever  their  market  value  may  be  at  the  time 
the  Balance  Sheet  is  dra\vii. 

But  the  accountant  may  object  that  this  is  not  the 
only  or  even  the  principal  purpose  of  the  Balance 
Sheet.  The  Balance  Sheet  is  supposed  to  show  the 
value  of  the  business  on  a  certain  date.  If  the  banker 
picks  up  the  Balance  Sheet,  he  will  be  misled  if  In- 
ventories are  valued  at  cost  when  their  market  value 
is  below  cost.  The  accountant  may  insist  that  the 
banker  is  not  so  much  interested  in  the  fixed  assets 
as  in  the  current  ones,  he  wants  to  be  shown  a  con- 
servative value  of  the  Inventories,  Eeceivables,  and 
Cash  so  that  he  may  have  some  idea  of  how  readily 
the  corporation  could  pay  off  his  loans  if  the  neces- 
sity should  arise.  Obviously,  it  would  be  bad  account- 
ing principle  to  value  the  Fixed  Assets  on  one  basis 
and  the  Current  Assets  on  another.  Furthermore,  a 
Balance  Sheet  would  have  to  be  made  for  a  par- 
ticular moment  and  might  be  useless  soon  thereafter. 
For  the  banker's  enlightenment  a  note  could  be 
appended  to  the  Balance  Sheet  A\'ith  regard  to  the 
value  of  the  Current  Assets,  particularly  the  Inven- 
tories, but  on  the  Balance  Sheet  original  cost  should 
prevail. 

The  valuation  of  the  Inventories  on  the  Profit  and 
Loss  account  in  determining  the  Cost  of  Sales  is 
also  disputed  by  accountants.  It  is  sometimes  argued 
that  *' safety  first"  would  involve  cost  or  market 
value,  whichever  happened  to  be  lower.  As  a  matter 
of  fact,  the  following  simple  example  will  show  that 
at  times  it  might  be  more  conservative  to  use  cost 
even  when  higher  than  market  value : 


134   ECONOMICS  FOR  THE  ACCOUNTANT 


Inventories 
at  Cost 

Inventories 
at  Market 

Sales 

$1.00 
.50 

$1200 
1000 

+  10 

$1200 

Cost  of  Production 

1000 

1st  Inventory  (10  units): 

Cost 

Market  Value 

+5 

Total 

$1010 
-10 

$1005 

2nd  Inventory  (5  units) : 

Cost 

Market  Value 

$2.00 
1.50 

-7.50 

Cost  of  Sales 

$1000 
$200 

$997.50 

Profit 

$202.50 

Thus,  the  valuation  at  cost  showed  a  smaller  profit 
and  is,  for  that  reason^,  more  conservative  in  this 
example  than  the  lower  market  valuation  would  have 
been.  However,  the  valuation  at  cost  should  not  be 
j"ustified  by  any  such  reasoning.  The  reason  why 
Inventories  should  be  valued  at  cost  rather  than  sell- 
ing price  on  the  Profit  and  Loss  account  is  connected 
with  the  fact  that  the  accountant  is  forced  to  con- 
sider an  arbitrary  fiscal  period  such  as  a  year.  An  ex- 
ample will  serve  to  illustrate  the  point.  If  10,000 
units  of  a  commodity  were  produced  in  November 
and  December  of  1916  at  a  cost  of  $0.10  per  unit  and 
if  100,000  units  were  produced  during  the  year  1917 
at  $0.20  per  unit,  the  total  cost  for  the  period 
from  November  1, 1916,  to  January  1, 1918,  would  be 
10,000  X  $0.10+100,000  X  $0.20,  or  $21,000.  If  the 
10,000  units  produced  in  1916  had  not  been  sold  by 


CAPITAL  AND   INVESTMENT  135 

the  end  of  tliat  year,  they  would  have  represented 
an  Inventory.  Now,  if  this  Inventory  had  been  sold 
in  1917,  the  profit  realized  would  have  been  the  dif- 
ference between  the  cost  of  $0.10  and  the  selling 
price,  which  might  have  been  $0.20.  Thus,  when  the 
accountant  adds  the  money  Inventory  to  the  year's 
cost,  he  is  really  adding  costs  of  two  periods, 
the  period  November-December,  1916,  and  the  period 
January  to  December,  1917.  The  same  reasoning 
applies  to  the  closing  Inventory.  If  there  are  certain 
units  left  over  after  the  end  of  the  year  1917,  the  cost 
of  those  units  should  be  deducted  from  the  total  costs 
expended,  that  is,  the  costs  of  the  period  November  1, 
1916,  to  January  1, 1918,  in  order  to  leave  the  costs  of 
the  units  disposed  of  by  the  end  of  1917. 


CHAPTER  XII 

PKICE,  PKOFIT,  AND  COST 

Profit  and  the  Entrepreneur. — In  all  that  has  gone 
before,  the  entrepreneur's  costs  have  been  discussed 
but  the  treatment  of  his  share,  profit,  has  been  post- 
poned for  this  chapter.  After  the  accountant  has 
determined  the  cost  of  producing  a  certain  article,  he 
needs  only  to  subtract  this  cost  from  the  selling  price 
in  order  to  determine  the  entrepreneur's  profit, 
assuming  that  the  accounting  cost  is  the  entrepren- 
eur's cost  and  includes  interest.  When  the  account- 
ant has  defined  cost  properly,  his  task  seems  ended. 
However,  if  past  costs  and  estimated  future  costs  are 
being  used  to  determine  selling  prices,  the  account- 
ant may  be  called  upon  to  fix  what  he  considers  a 
proper  margin  of  profit  to  be  added  to  cost.  It  is  evi- 
dent that  although  the  accountant  may  decide  on 
what  should  go  into  cost,  he  cannot  determine  in  a 
competitive  system  what  price  or  profit,  the  differ- 
ence between  price  and  cost,  is  actually  going  to  be. 
If  price  is  fixed  by  competition,  no  one  producer  can 
sit  at  his  desk  and  fix  his  price  or  profit  independ- 
ently. But  it  is  probably  more  dangerous  for  the  ac- 
countant to  misunderstand  the  nature  of  profit  than 
any  of  the  other  economic  categories. 

It  was  stated  on  page  45  in  Chapter  IV  that  profit 
is  the  share  of  the  entrepreneur,  but  just  who  the 

136 


PRICE,  PROFIT  AND  COST  137 

entrepreneur  is  and  just  what  lie  does  has  not  yet 
been  completely  discussed.  In  a  private  business  this 
function  is  vested  in  the  ultimate  ''boss,"  and  in  a 
corporation  in  the  stockholders.  In  Chapter  III  it 
was  explained  that  the  entrepreneur  controls  the 
business  unit;  actually  only  one  part  of  the  entre- 
preneur, the  controlling  stockholders  or  directors, 
has  any  voice  in  shaping  its  policies.  It  is  often 
thought  that  the  entrepreneur  must  render  actual 
personal  service  either  in  organizing  or  directing, 
and  that  he  is  really  a  high  type  of  laborer.  As  a 
matter  of  fact,  his  service  is  never  active;  if  he 
works,  he  receives  a  salary  and  is  a  laborer. 

The  Pure  Entrepreneur. — Inasmuch  as  most  of  the 
entrepreneurs  are  also  capitalists  (the  partners  in 
an  unincorporated  business  and  the  stockholders  in 
a  corporation,  who  furnish  it  with  capital  when  they 
buy  its  stock)  it  is  often  assumed  that  the  function 
cannot  be  vested  in  a  man  or  group  of  men  unless  he 
or  they  be  also  capitalists.  It  seems  worthy  of  con- 
sideration that  during  the  last  decade  a  type  of  im- 
portant industrial  corporation  has  sprung  up  in 
which  the  capitalist  and  entrepreneur  functions  are 
often  separated,  at  least  temporarily.^  Some  of  the 
most  important  of  our  private  businesses  are  being 
refinanced  in  a  way  that  has  already  been  described 
on  page  124  in  the  preceding  chapter.  The  original 
owner  sells  his  business  to  a  newly  created  corpora- 
tion and  receives  for  it  an  issue  of  preferred  stock, 
equal  in  value  to  the  capital  in  the  business,  and  an 

*See  Kemper  Simpson,  "The  Capitalization  of  Industrial  Good 
Will,"  John  Hopkins  Press. 


138      ECONOMICS  FOR  THE  ACCOUNTANT 

issue  of  common  stock,  behind  whicli  is  ''Goodwill" 
or  "water."  The  preferred  stock,  then,  is  sold  in  the 
stock  market  by  the  original  owners,  who  are  nsually 
expected  or  even  required  to  hold  the  common  stock. 
The  preferred  stockholders,  thus,  replace  the  capital 
withdrawn  by  the  original  entrepreneur-capitalist; 
they  become  the  capitalists  but  he  remains  the  entre- 
preneur because  he  holds  the  common  stock.  He  has 
sold  his  capital  and  is  a  pure  entrepreneur  until  he 
puts  back  some  of  his  profits  in  the  business. 

It  might  be  maintained  that  the  capitalists  allow 
him  to  be  the  entrepreneur  because  of  his  ability  as  a 
laborer  and  that  he  is  really  a  laborer-entrepreneur. 
Some  of  these  common  stockholders  withdraw  from 
active  participation  in  the  business  and  merely 
control  its  policy.  Yet,  they  always  own  its  product 
and  its  capital  goods.  The  capitalist,  it  must  be 
conceded,  commonly  expects  the  entrepreneur  either 
to  invest  some  of  his  own  capital  or  to  apply  a  high 
degree  of  executive  ability  and  to  render  personal 
service.  The  capitalist  wants  assurance  that  the 
entrepreneur  will  be  able  to  meet  his  obligations  in 
the  event  of  dissolution,  should  the  capital  goods  de- 
preciate in  value.  Although  at  the  inception  of  these 
reincorporations  the  entrepreneur  and  capitalist 
functions  were  embodied  in  different  persons  or 
groups  of  persons  in  the  new  industrial  companies 
just  described,  as  soon  as  profits  were  earned  and 
were  not  withdrawn,  the  capital  was  increased  and 
the  entrepreneur  automatically  became  a  capitalist. 
However,  although  the  entrepreneurial  function  and 
the  capitalist  function  are  commonly  embodied  in  one 


PRICE,  PROFIT,  AND  COST  139 

man,  these  functions  are  separate  and  distinct  and 
should  not  be  confused  with  each  other. 

Functions  of  the  Entrepreneur. — The  pure  entre- 
preneur is  neither  laborer  nor  capitalist;  he  merely 
owns  the  capital  goods  and  the  product  and,  through 
his  ownership,  holds  control.  In  what  active  ways 
does  he  exert  his  control?  First,  if  he  is  the  original 
stockholder,  he  may  organize  the  business  unit.  If 
he  does  not  do  this  directly,  he  hires  the  laborers 
who  do.  Thus,  the  first  stockholders  are  directly 
responsible  for  the  formation  and  location  of  the 
particular  aggregation  of  land,  labor,  and  capital 
goods  that  make  up  the  business  unit.  If  they  do  no 
actual  work,  they,  at  least,  had  the  original  idea  of 
the  business.  Second,  they  make  decisions  as  to  the 
general  policy  of  the  company  whenever  they  vote. 
If  they  merely  sign  proxies,  they  surrender  their 
rights  to  the  directors. 

The  ownership  of  the  capital  goods  and  of  the 
product  are  always  the  function  of  the  entrepreneur, 
but  the  organization  and  control  function  are  usually 
vested  in  one  part  of  the  entrepreneur  only.  Al- 
though all  of  the  common  stockholders  regularly 
have  a  right  to  vote,  the  control  is  probably  held  by  a 
few  of  the  directors,  who  are  elected  by  the  majority 
stockholders.  Thus,  many  of  the  common  stock- 
holders of  modern  corporations  merely  supply 
capital  on  easy  terms,  that  is,  they  do  not  have  to  be 
assured  an  interest  return,  because  they  are  prom- 
ised an  equal  share  of  the  profits  if  any  are  earned. 
Theoretically,  however,  they  are  a  part  of  the  entre- 
preneur because  they  own  the  capital  goods  and  the 


140   ECONOMICS  FOR  THE  ACCOUNTANT 

product  and  they  have  the  legal  right  to  vote,  even 
though  customarily  they  are  satisfied  to  sign  proxies. 
The  Risk  Theory  of  Profit. — Inasmuch  as  the 
share  of  the  entrepreneur  is  profit  and  as  so  many 
stockholders  are  merely  part  owners  of  the  product 
and  the  capital  goods,  it  has  come  to  be  believed  by 
many  economists  that  this  ownership  and  the  risk 
inherent  in  it  justifies  or,  at  least,  explains  profit. 
The  risk  theory  of  profit  is  so  widely  held  that  it 
deserves  some  attention.  The  following  paragraph 
is  taken  from  an  article  published  by  me  in  the 
Quarterly  Journal  of  Economics  for  November, 
1919: 

There  seems  to  be  no  risk  in  ownership,  per  se,  that  would 
warrant  compensation.  The  risk  in  the  ownership  of  the 
product  can  be  analyzed  into  two  parts :  the  risk  inherent 
in  the  possibility  of  not  getting  profit,  and  the  risk  of 
losing  the  capital  or  a  part  of  the  capital  invested  in  the 
product.  With  respect  to  the  first  kind  of  risk,  no  factor 
in  production  is  absolutely  assured  of  a  share  in  distribu- 
tion. This  is  true  of  the  laborer,  although  it  is  more 
conspicuous  in  the  case  of  the  capitalist  and  landowner. 
If  an  entrepreneur  were  to  be  compensated  according  to 
the  risk  he  ran  of  getting  profit,  the  most  inefficient  entre- 
preneurs could  expect  the  highest  rate  of  profit.  With 
regard  to  the  second  kind  of  risk,  Hawley  acknowledges 
that  this  is  a  capitalist's  risk  and  not  an  entrepreneur's 
risk.  If  the  entrepreneur  uses  his  own  capital,  he  takes 
a  risk  as  capitalist  and  not  as  entrepreneur.  If  he  borrows 
his  capital,  the  lender  takes  the  risk.  The  risk  inherent  in 
the  ownership  of  the  product  offers  no  sufficient  justifica- 
tion for  profit  nor  does  it  explain  the  variations  in  profit. 
The  justification  for  the  varying  yields  on  capital  due  to 
different  degrees  of  risk  has  been  generally  recognized. 


PRICE,  PROFIT,  AND  COST  141 

The  capitalist  does  not  take  the  risk  of  not  getting  interest 
but  he  stands  the  chance  of  losing  his  capital,  i.e.,  the 
source  of  his  income.  "Wlien  a  laborer  is  paid  a  high  wage 
in  a  dangerous  occupation,  he  is  compensated  for  the  risk 
of  losing  his  wage. 

The  risks  of  the  factors  of  production  may  be 
eummarized  as  follows : 

1.  (a)  Laborer  takes  little  risk  of  losing  wage 

because  he  is  paid  first,  (b)  He  takes  little 
risk  of  losing  source  of  his  wage,  that  is, 
limb  or  life,  except  in  dangerous  occupation, 
where  he  demands  a  higher  wage,  as  risk 
premium. 

2.  (a)  Landoivner  and  owner  of  capital  goods, 

such  as  buildings,  etc.,  takes  slightly 
greater  risk  of  not  getting  his  share  than 
laborer  does  of  not  getting  his.  Tenants 
do  not  always  pay  rent,  (b)  He  takes  little 
risk  of  losing  the  source  of  his  rent,  his 
land,  but  he  may  lose  his  capital  goods ;  so 
he  insures  them,  and  charges  the  insurance 
in  his  rent. 

3.  (a)  The  capitalist  takes  a  risk  equal  to  that  of 

landowner,  or  greater,  of  not  getting  in- 
terest, (b)  He  takes  a  considerable  chance 
of  losing  his  principal,  as  capital  is  often 
very  soon  dissipated. 

4.  (a)  The  entrepreneur  takes  the  greatest  chance 

of  losing  his  profit  because  he  is  paid  last. 
(b)  He  takes  no  risk  of  losing  the  source  of 
his  profit  in  the  way  the  capitalist  risks  los- 
ing his  principal. 


142   ECONOMICS  FOR  THE  ACCOUNTANT 

If  risk  explained  different  profits  in  the  way  that 
it  explains  different  rates  of  interest,  the  marginal 
entrepreneur,  who  takes  the  greatest  risk  of  failure, 
would  theoretically  get  the  greatest  profit,  a  reductio 
ad  dbsurdum.  There  is  one  sense  in  which  profits 
might  be  affected  by  risk;  in  precarious  industries, 
capital  ventures  cautiously  and  there  would  theoret- 
ically be  few  entrepreneurs,  little  competition,  and 
great  profits.  This,  however,  is  not  the  relation 
between  profit  and  risk  that  some  economists  have 
claimed  exists.  And  certainly  this  relation  would 
offer  no  good  ground  for  justifying  profit  as  a  return 
for  the  risk  the  entrepreneur  runs.  The  risk  of  the 
entrepreneur  is  not  to  be  compared  with  the  capital- 
ist's risk,  and  differences  in  interest  rates  are 
explained  by  differences  in  risk,  whereas  differences 
in  profits  are  not  so  explained. 

The  Reason  for  Profit. — As  the  risk  in  the  owner- 
ship of  the  product  and  the  capital  goods  does  not 
explain  profit,  it  is  necessary  to  consider  the  origin 
and  the  nature  of  profit  before  it  can  be  explained 
why  the  entrepreneur  gets  this  share.  When  a 
number  of  producers  bring  their  products  into  a 
market,  each  one  will  have  a  more  or  less  accurate 
idea  of  his  cost,  below  which  he  will  not  want  to  sell. 
The  very  low-cost  producers  have  no  fear  because 
they  know  that  any  price  that  prevails  can  be 
expected  to  cover  their  costs  and  give  them  profits. 
The  costs  of  the  different  producers  can  be  repre- 
sented graphically.  The  costs  sho\\Ti  below  are  unit 
costs,  that  is,  costs  per  unit  of  product,  for  10 
producers  who  manufacture  an  article  of  a  standard 


PRICE,  PROFIT,  AND  COST 


143 


grade.  These  producers  are  assumed  to  be  the  only 
producers  in  the  industry.  These  costs  include 
interest. 


•«ro»it" 


fROFlT    PROFIT    M>AM* 
1     ["r'      roOFIT  pRopiT 


PROFIT  PROFIT  pRoFIT 


GRAPHICAL  REPRESENTATION  OF  PROFIT  AND  LOSS  IN  RELATION  TO  COST 
OF  PRODUCTION 

Assuming  that  the  production  period,  for  which 
these  costs  are  sho^vn,  is  a  normal  one,  the  producer 
whose  cost  just  equals  price  is  defined  as  the 
marginal  producer.  Why  price  was  assumed  to  fall 
just  where  it  did  will  be  explained  in  the  next  para- 
graph. The  marginal  producer,  II,  made  no  profit ; 
the  very  highest  cost  producer,  I,  showed  a  loss. 
Each  of  the  eight  producers,  whose  costs  were  less 
than  that  of  the  marginal  producer,  made  a  profit, 
which  varied  inversely  with  the  size  of  his  cost.  It 
appears,  therefore,  that  profit  was  realized  by  reduc- 
ing cost  below  marginal  cost  or  price. 

It  is  interesting  to  consider  the  relation  between 
productivity  and  the  reduction  of  cost.  It  has  been 
shown  that  the  lowest-cost  producer  earns  the  high- 
est profit,  that  the  highest-cost  producer  earns  the 
least  profit,  and  that  differences  in  profit  are  com- 
monly explained  by  ability  or  luck  in  the  reduction  of 
cost.     The  productivity  theory  maintains  that  the 


144   ECONOMICS  FOR  THE  ACCOUNTANT 

most  productive  entrepreneur  tends  to  receive  the 
greatest  profit  and  vice  versa.  Therefore,  if  the  two 
explanations  of  profit  are  consistent,  the  lowest-cost 
entrepreneur  would  be  the  most  productive  entre- 
preneur. This  is  theoretically  true  and  can  be  ex- 
plained by  an  example. 

If  two  entrepreneurs  had  costs  of  $100,000  each, 
but  one  produced  1,000,000  units  of  product  and  the 
other  only  900,000  units,  the  first  would  have  the 
lower  cost  and  be  the  more  productive.  Thus,  the 
lowest-cost  producer  is  the  producer  who  gets  the 
largest  quantity  of  product  per  dollar  of  money 
expended  in  cost. 

It  has  been  assumed  that  price  covered  the  costs 
of  most  of  the  producers.  However,  if  the  demand 
for  the  article  produced  had  fallen  off  because  of  the 
introduction  of  a  substitute  or  for  any  other  reason, 
the  price  might  have  fallen  so  low  as  to  have  equaled 
the  cost  of  producer  IV  on  page  143.  If,  by  any 
chance,  these  producers  had  produced  very  much 
more  than  the  market  demanded,  price  would  never 
have  been  maintained  at  the  cost  of  the  marginal 
producer.  When  price  falls  very  much  below 
marginal  cost,  considerable  losses  are  incurred.  In 
the  next  production  period,  the  existing  producers 
may  curtail  output  or  some,  who  suffered  heavy  loss, 
may  even  have  to  mthdraw  from  the  industry.  Then, 
when  supply  is  reduced  and  demand  decreased  no 
further,  price  rises  and  may  even  cover  the  cost  of 
highest-cost  producer,  I.  During  the  World  War 
when  the  supply  of  commodities  was  so  short  and 
the  demand  was  so  great,  prices  rose  high  above 


PRICE,  PROFIT,  AND  COST  145 

marginal  costs,  and  profits  were  abnormally  large. 

The  entrepreneur's  profit  is  not  always  explained, 
then,  by  the  fact  that  his  cost  is  below  the  marginal 
cost  but  also  by  the  maladjustment  of  supply  and 
demand  and  by  the  divergence  of  price  from 
marginal  cost.  When  producers  get  together  and  fix 
prices  above  marginal  cost  or  when  the  supply  is 
short  relative  to  the  demand,  profits  are  earned  by 
the  marginal  producer  who,  in  normal  periods  and 
under  conditions  of  competition,  is  supposed  to 
receive  no  profits.  Again,  a  producer  can  advertise 
an  ordinary  article  in  such  a  way  that  the  consumer 
will  be  mlling  to  pay  a  higher  price  for  it  than  for 
unadvertised  articles  of  the  same  grade. 

Principal  Kinds  of  Profit. — It  is  now  possible  to 
classify  the  different  kinds  of  profit  that  the  entre- 
preneur receives.  First,  he  can  obtain  profit  by 
selling  some  of  his  capital  goods,  land,  materials, 
machinery,  etc.,  for  more  than  they  cost.  Second,  he 
can  obtain  profit  when  his  price  is  above  marginal 
cost.  Third,  he  can  make  a  profit  by  having  a  lower 
cost  than  that  of  the  marginal  producer.  The  third 
method  is  the  most  important  and  the  most  perma- 
nent. It  is  necessary,  therefore,  to  consider  what  en- 
titles the  entrepreneur  to  this  kind  of  profit. 

From  the  foregoing  analysis  it  might  seem  that 
the  profit  is  the  result  of  the  entrepreneur's  product- 
ivity. It  is  sometimes  stated  the  entrepreneur's 
profit  arises  merely  because  he  underpays  his  labor- 
ers and  because  he  deprives  the  capitalist  and  the 
landowner  of  what  belongs  to  them.  In  other  words, 
profit  is  said  to  exist  only  when  the  wages  paid  are 


146      ECONOMICS  FOR  THE  ACCOUNTANT 

less  than  the  productivity  of  the  laborers,  etc.  As  a 
matter  of  fact,  if  the  specific  productivity  of  labor 
could  be  ascertained,  it  would  have  to  be  admitted 
that  what  the  laborers'  efforts  seem  to  produce  may 
be  in  part  due  to  the  situation  in  which  the  entre- 
preneur places  them.  If  an  entrepreneur,  not  his 
agents,  places  the  laborers  in  a  position  where  their 
productivities  are  increased,  he  may  be  considered 
responsible  for  a  part  of  the  product  that  they  may 
seem  to  produce  independently. 

It  has  been  pointed  out  by  some  economists  that 
the  entrepreneur  is  seldom  directly  responsible  for 
any  increase  in  the  productivities  of  the  other  factors 
and  that  his  managers,  efficiency  experts,  and  ac- 
countants should  be  given  the  credit  of  reducing  cost. 
This  is  undoubtedly  true  and  should  argue  for  a 
profit-sharing  or  bonus  system  especially  for  the 
more  important  employees.  In  corporations,  which 
are  the  most  important  type  of  business  organization 
to-day,  the  common  stockholders  are  the  entrepren- 
eur. In  most  of  the  important  corporations,  the  or- 
dinary common  stockholder  has  very  little'  to  say  or 
to  do,  except  to  lend  his  capital,  which  he  does  as 
capitalist  not  as  entrepreneur.  If  the  common  stock- 
holder actually  works,  that  is,  labors,  he  receives  a 
salary  in  cost  and  he  could  hardly  claim  additional 
profit  for  his  personal  service,  particularly  if  the 
salary  allowed  were  sufficient.  It  must  be  empha- 
sized that  the  profit,  the  dividend  minus  pure  inter- 
est, obtained  by  the  ordinary  common  stockholder, 
who  merely  signs  a  proxy,  is  seldom  productivity 
profit  but  is  given  him  because  he  is  willing  to  lend 


PRICE,   PROFIT,  AND  COST  147 

his  capital  without  rigid  interest  requirements.  He 
foregoes  the  rigid  interest  requirements  in  order  to 
be  allowed  to  participate  in  the  profits  when  earned. 

The  original  stockholders  of  a  company  often  have 
an  idea  that  is  productive  and  that  reduces  cost,  and 
even  though  they  may  give  no  personal  service  and 
may  actually  work  in  other  corporations,  they  may 
be  said  to  earn  their  profit.  But  there  are  many 
kinds  of  profits  that  are  not  easily  justified.  Wher- 
ever trade-union  organization  is  not  effective,  it  is 
evident  that  the  entrepreneur's  superior  bargaining 
power  will  enable  him  to  pay  lower  wages  than  the 
productivities  of  his  laborers  would  justify.  The 
profits  that  result  from  the  sale  of  capital  goods  or 
from  inflated  prices  are  often  the  result  of  luck,  but 
it  must  be  conceded  that  the  profit  that  is  caused  by 
a  short  supply  or  an  increased  demand  is  often  due 
to  the  entrepreneur's  judgment  of  a  future  market 
and  that  the  service  he  performs  in  producing  for 
such  a  market  deserves  profit. 

The  Relation  between  Price  and  Cost. — The  rela- 
tion between  price  and  cost  sliow^s  clearly  that  the 
entrepreneur  cannot  merely  add  a  certain  percentage 
of  his  investment  to  his  cost  in  order  to  determine 
his  selling  price.  A  competitively  fixed  price  may 
allow  the  low-cost  producer  as  much  as  50  per  cent 
on  his  investment,  whereas  it  may  allow  a  high-cost 
producer  less  than  one  per  cent.  There  is,  however, 
an  interesting  relation  between  the  total  investment 
and  the  gross  profit,  or  economic  interest  plus  profit, 
for  the  industry  as  a  whole.  It  can  be  set  forth  best 
by  presenting  the  results  of  a  statistical  study  made 


148   ECONOMICS  FOR  THE  ACCOUNTANT 

in  the  Quarterly  Journal  of  Economics,  of  February, 
1921. 

Six  industries,  for  wliich  cost  data  had  been  col- 
lected, were  considered  in  this  analysis.  For  some 
of  these  industries  costs  for  only  one  year  were  pub- 
lished, whereas  in  other  industries  costs  for  as  many 
as  four  years  were  available.  It  was  found  that,  for 
the  industries  considered,  price  approximated  bulk- 
line  or  marginal  cost  when  the  total  gross  profit, 
interest  plus  profit,  of  all  the  producers  represented 
from  about  9  to  12  per  cent  of  their  total  invest- 
ment and  that  price  was  below  or  above  bulk-line 
cost  when  the  industry's  gross  profit  on  investment 
was  less  or  more  than  from  about  9  to  12  per  cent 
of  the  industry's  investment.  By  "bulk-line"  cost 
was  meant  the  cost  below  which  the  bulk  of  the 
production  occurred.  Thus,  in  Table  I  below, 
Group  m  is  the  group  in  which  the  average  cost, 
$32.21,  fell,  but  it  is  not  the  bulk-line  group  and 
$32.21  is  not  the  bulk-line  cost.  Group  V  is  the  bulk- 
line  group  because  the  costs  between  $36  and  $40 
are  just  high  enough  to  cover  the  costs  at  which  the 
bulk  of  the  output  was  produced.  It  should  be  noted 
that  the  bulk-line  group  is  not  the  highest  cost  group. 
The  highest  cost  group  in  the  following  table  would 
have  added  so  little  to  the  product  that  the  bulk 
thereof  is  accounted  for  without  considering  it. 
Tables  I  and  II  opposite  illustrate  this  principle. 

The  bulk-line  producers  showed  costs  of  from 
about  $36  to  $40.  Adding  an  estimated  interest  of 
$4.30,  because  the  costs  in  this  table  include  no  inter- 
est, it  is  evident  that  the  bulk-line  cost  was  above 


PRICE,   PROFIT,  AND  COST  149 

I.  The  Cost  op  Producing  a  Ton  of  News-Print  Paper  in  1915 


Cost  Groups 

Number 
of  Mills 

Tons 
Produced 

Per  Cent 
of  Total 

Average 

Cost 
per  ton 

I    Less  than  $27 

3 

2 
8 
11 
8 
3 

195,820 
138,934 
260,505 
276,672 
120,199 
33,321 

19.1 
13.5 
25.4 
27.0 
11.7 
3.3 

$26 . 64 

11.  $27  and  less  than  $30. 

III.  $30  and  less  than  $33. 

IV.  $33  and  less  than  $36. 
V.  $36  and  less  than  $40. 

VI.  $40  and  over 

28.51 
31.64 
34.75 
37.74 
43.67 

35 

1,025,461 

100.0 

$32.21 

the  average  price  received,  which  in  1915  was  only 
$38.45.  However,  the  industry  only  earned  about 
six  per  cent  gross  profit  on  its  investment  in  1915. 

II.  The  Costs  of  Producing  a  Pound  op  Copper  in  1918 


Num-. 

ber 

of 
Com- 
panies 

Pounds 
Produced 

Per 
Cent 

of 
Total 

Aver- 
age 

Cost 
per 

pound 

Aver- 
age 

Selling 

price 
per 

pound 

Aver- 
age 
Invest- 
ment 
per 
pound 

Cost  less  than  15ff 
Cost  15    to  17H  ■  ■ 
Cost  17*  to20ff.... 
Cost  20    to  21^.... 
Cost  21    to225f.... 
Cost  22    to24ff.... 
Cost 24    to28f^... 
Cost  over  28  j5 

6 

7 
8 
5 
5 
7 
8 
7 

424,340,257 
395,672,390 
169,578,109 
36,871,193 
91,812,263 
90,111,068 
33,955,962 
11,426,343 

33.84 

31.56 

13.53 

2.94 

7.32 

7.19 

2.71 

91 

12.630 
16.284 
18.078 
20.477 
21.605 
22.090 
26.273 
35.989 

24.357 
24.430 
25.073 
23.664 
23.108 
24.207 
24.455 
24.172 

22.428 
33.278 
31.453 
40.419 
36.412 
29.998 
20.961 
93.629 

Total  and  Average 

53 

1,253,767,585 

100.00 

16.700 

24.388 

29.779 

150   ECONOMICS  FOR  THE  ACCOUNTANT 

The  average  selling  prices  realized  by  the  pro- 
ducers in  the  different  cost  groups  varied  somewhat; 
but  the  average  selling  price  for  all  the  companies 
was  24.388  cents.  The  bulk-line  companies  received 
approximately  24  cents  for  their  product.  The  Gov- 
ernment fixed  the  price  of  copper  at  231^  cents  a 
pound,  effective  September  21,  1917,  and  this  price 
prevailed  until  July  2,  1918,  when  it  was  put  at  26 
cents  and  remained  so  for  the  balance  of  the  year. 

The  investment  also  varied  for  the  different  com- 
panies, but  it  is  obvious  that  the  93.629  cents  per 
pound  group  presented  the  "flotsam  and  jetsam  of 
economic  life."^  The  investment  of  the  bulk-line 
producers  was  probably  somewhere  between  20  and 
30  cents.  Thus,  interest  at  five  per  cent  would  be 
about  1  cent  or  li/^  cents.  If  this  interest  deduction 
be  subtracted  from  the  price,  the  result  would  be 
anywhere  from  22.5  to  23.5  cents.  The  bulk-line  cost 
seems  to  be  about  20  cents.  Thus,  price  was  even 
above  the  bulk-line  or  marginal  costs.  This  is 
explained  by  the  fact  that  the  industry  averaged 
more  than  25  per  cent  on  its  investment. 

It  was  stated  on  page  106  that  one  reason  why  it 
seems  preferable  to  have  the  accountant's  cost  coin- 
cide with  the  entrepreneur's  cost,  rather  than  the 
entrepreneur-capitalist's  cost,  would  be  set  forth  in 
this  chapter.  When  the  accountant  excludes  inter- 
est from  his  cost,  the  difference  between  price,  or 
sales,  and  cost  is  "Gross  Profit,"  that  is,  interest 
plus  profit.     Inasmuch  as  interest  bears  a  definite 

'  The  highest-cost  producers,  not  the  marginal  or  bulk-line  pro- 
ducers. 


PRICE,   PROFIT,  AND  COST  151 

relation  to  capital  or  investment,  the  accountant 
sometimes  assumes  that  the  Gross  Profit  and  even 
the  pure,  or  economic,  profit  also  bears  a  definite 
relation  to  the  producer's  investment.  This  failure 
to  distinguish  between  interest  and  profit  has  led 
some  accountants  to  believe  that  the  different  per- 
centages of  return,  gross  profit  divided  into  invest- 
ment, obtained  from  different  aggregations  of  capital 
goods  are  varying  rates  of  interest  on  the  capital 
invested.  Some  social-minded  accountants  have 
gone  so  far  as  to  believe  that  if  a  fixed  return  of  10 
or  15  per  cent  gross  profit  is  exceeded,  the  producer 
becomes  a  profiteer;  they  apparently  fail  to  recog- 
nize the  desirability  of  having  the  producer  reduce 
his  costs,  and  they  neglect  the  very  important  dis- 
tinction between  interest  and  profit.^ 

•  See  Appendix  I. 


CHAPTER  Xni 

COMPETITION 

The  Assumptions  of  Competition. — Tlie  economic 
organization  of  society  under  which  we  live  is  often 
called  the  * '  competitive  system. ' '  In  many  places  in 
the  foregoing  chapters,  "normal  conditions  of  com- 
petition" were  assumed.  What  is  meant  by  "com- 
petition"? There  are  two  fundamental  principles 
involved:  first,  every  individual  is  assumed  to  be 
working  for  himself  by  buying  what  he  needs  as 
cheaply  as  possible  and  by  selling  what  he  has  for 
as  high  a  price  as  possible;  second,  each  individual 
is  supposed  to  be  working  not  only  for  himself  but 
also  by  himself  and  not  in  concert  with  others  of 
his  class. 

The  laborer,  the  landowner,  and  the  capitalist  are 
supposed  to  charge  for  what  they  give  in  production 
as  high  a  return  as  they  can  get.  If  they  are  not 
receiving  so  high  a  wage,  rent,  or  interest  in  one 
industry  as  they  could  receive  in  another  industry, 
they  are  supposed  to  withdraw  from  the  first  and 
enter  the  second  industry.  The  fluidity  of  labor, 
capital,  capital  goods,  and  land,  then,  is  a  corollary 
of  the  first  principle  of  competition.  By  the  fluidity 
of  land  is  meant  that  if  corn  does  not  pay,  the  acre- 
age may  be  turned  to  rye.  The  entrepreneur,  too, 
is  supposed  to  get  the  best  price  he  can  and  to  go 

152 


COMPETITION  153 

to  the  most  profitable  industry.  The  buyers  of  eco- 
nomic goods,  of  which  group  the  consumers  are  the 
most  important  members,  are  assumed  to  be  getting 
the  lowest  possible  prices. 

The  second  principle  assumes  that  no  individual 
in  any  of  the  economic  classes  indicated  should  com- 
bine with  any  other  individual  in  his  class  to 
strengthen  his  bargaining  power.  Thus,  the  laborer 
is  supposed  to  bargain  individually  with  the  particu- 
lar entrepreneur  for  whom  he  works.  The  entre- 
preneurs are  not  supposed  to  combine  in  fixing 
prices. 

It  is  obvious  that  the  assumptions  of  competition 
are  not  always  valid.  The  fluidity  of  labor,  capital, 
capital  goods,  and  land  is  not  always  so  automatic 
as  it  is  believed  to  be.  Laborers,  who  have  acquired 
skill  in  one  occupation,  cannot  always  change  their 
crafts  on  short  notice.  Many  laborers  prefer  to  work 
for  their  old  employers  at  lower  wages  than  to  make 
a  change.  Capital,  which  has  been  transferred  into 
fixed  capital  goods,  cannot  be  shifted  readily  from 
one  industry  to  another.  Swords  cannot  literally  be 
made  into  plowshares.  Moreover,  ignorance  and 
carelessness  may  explain  much  of  the  immobility  of 
the  factors  of  production. 

The  producer  does  not  always  get  the  market 
price,  particularly  if  he  is  located  at  a  great  distance 
from  the  market.  The  consumer  through  ignorance 
or  through  unwillingness  and  inability  to  "shop" 
may  pay  too  much  for  a  particular  brand.  The  con- 
sumer, to-day,  is  forced  to  place  too  much  depend- 
ence on  the  seller's  advertisement.    The  trade,  as  a 


154      ECONOMICS  FOR  THE  ACCOUNTANT 

whole,  Tinder  the  supervision  of  a  governmental 
agency  might  be  required  to  submit  the  products 
manufactured  to  the  test  of  experts,  and  a  standard- 
ization could  be  based  thereon.  The  Bureau  of 
Markets  of  the  Department  of  Agriculture  is 
attempting  to  establish  grades  and  to  preach 
standardization  in  food  products. 

Collective  Bargaining. — All  of  these  interferences 
with  the  free  play  of  competition  are  generally  recog- 
nized by  economists,  but  are  considered  only  tempor- 
ary and  incidental  interferences,  which  do  not  affect 
the  broad,  general  principles  involved.  None  of 
these  interferences,  however,  are  so  noteworthy  as 
the  fallacy  involved  in  the  belief  that  free,  absolutely 
unrestricted  competition  tends  to  give  to  each  factor 
of  production  what  can  be  specifically  imputed  to 
that  factor's  service.  Such  a  theory  would  imply 
that  the  bargaining  power  of  the  entrepreneur  and 
the  laborer  are  equal.  The  greater  wealth  of  the 
entrepreneurs  and  the  fact  that  there  are  many  more 
laborers  than  entrepreneurs  would  enable  the  entre- 
preneur to  keep  a  large  part  of  the  laborer's  produc- 
tivity, were  not  laborers  organized.  Collective 
bargaining  theoretically  enables  the  laborer  to  get 
what  he  produces,  whereas  unrestricted  competition 
would  probably  not  give  it  to  him.  If  collective 
bargaining  gives  the  laborer  more  than  he  produces, 
it  might  be  considered  uneconomical,  according  to 
the  productivity  theory.  However,  it  was  suggested 
on  page  40  in  Chapter  IV  that  it  might  be  advisable 
and  even  ethical  to  allow  laborers  more  than  their 
specific  productivities,  even  though  it  might  retard 


COMPETITION  155 

slightly  the  growth  of  capital  and  the  development 
of  enterprise.  It  has  been  explained  that  the  econ- 
omist's first  interest  is  in  the  consumer.  However, 
it  has  come  to  be  realized  that  even  though  collec- 
tive bargaining  may  lead  to  higher  wages,  higher 
costs,  and  higher  prices,  the  laborer  needs  as  much 
attention  as  the  consumer,  particularly  if  the  non- 
union and  unorganized  workers  be  classed  with  the 
organized  workers,  because  the  incomes  of  the  great 
bulk  of  the  consumers  are  wages. 

Price  Control. — There  is  another  interference  with 
free  competition  that  the  economist  does  not  con- 
sider so  favorably,  namely,  price  control  by  pro- 
ducers. It  was  explained  in  Chapter  XII  that  price 
tends  to  be  equal  to  the  cost  of  the  bulk-line  pro- 
ducers under  normal  conditions  of  competition.  If 
the  producers  in  an  industry  combined  to  fix  a  price 
above  the  marginal  or  bulk-line  cost,  they  could 
maintain  it,  provided  the  demand  were  not  seriously 
affected.  The  producers  usually  fix  prices  in  their 
trade  association  meetings.  Under  the  guise  of 
cost  discussion,  they  often  determine  upon  selling 
prices.  The  Federal  Trade  Commission  has  investi- 
gated the  price-fixing  activities  of  some  of  the  State 
canning  associations  in  the  Middle  West.  The  fol- 
lowing paragraphs  are  taken  from  the  Commission's 
report  :^ 

The  Iowa  and  "Wisconsin  associations  apparently  went 
farthest  in  price  discussions  and  agreements.  An  extract 
from  the  minutes  of  the  meeting  of  the  Iowa  association  on 

*  Report  of  the  Federal  Trade  Commission  on  Canned  Foods,  May 
15,  1918.     Government  Printing  Office,  Washington. 


156      ECONOMICS  FOR  THE  ACCOUNTANT 

September  27,  1916,  runs  as  follows:  "It  was,  however,  the 
general  opinion  that  it  is  advisable  not  to  open  prices  until 
after  the  annual  meeting  in  November,  and  possibly  not 
before  the  first  of  the  year."  Of  the  meeting  of  January 
3,  1917,  the  secretary  in  his  report  dated  November  6,  1917, 
said: 

After  the  first  of  January  ...  we  felt  it  was  time  to 
offer  goods  for  future  delivery,  and  based  on  our  estimate 
of  such  costs,  we  felt  that  90  cents  for  standard  corn  was  as 
cheap  as  we  could  pack  it  .  .  .  Most  Iowa  packers  offered 
goods  at  that  price.  There  was  no  collusion  or  agreement 
of  any  kind  between  packers,  but  simply  a  general  con- 
sensus of  opinion  that  we  could  not  afford  to  sell  it  cheaper. 
This  was,  I  think  at  least  15  cents  per  dozen  higher  than 
any  opening  price,  .  .  .  and  it  seemed  doubtful  if  the  trade 
would  accept  it.  But  it  remained  to  be  proven  that  we  can 
make  a  reasonaMe  price,  even  if  it  ie  Tiigher  than  all 
precedent,  and  sell  our  product  at  that  price. 

Rule  5  of  the  Iowa  association,  to  which  all  members  have 
agreed,  reads:  "We  agree  that  we  will  not  offer  to  sell 
future  corn  any  year  before  a  meeting  is  held  by  the  associa- 
tion, called  specifically  to  discuss  the  opportune  time  for 
opening  futures." 

The  Commission  is  in  possession  of  copies  of  letters  show- 
ing that  members  of  this  association  reached  agreements  as 
to  prices,  as  to  time  when  prices  were  to  be  advanced,  and 
showing  activity  of  the  secretary  in  holding  members  in 
line  on  prices  and  in  inducing  members  with  low  prices  to 
withdraw  them  and  make  quotations  in  line  with  those  of 
other  Iowa  packers.  The  secretary  has  even  gone  so  far  as 
to  offer  to  purchase  the  product  of  canners  who  have  made 
low  prices,  and  this  secretary  stated  to  an  examiner  of  the 
Federal  Trade  Commission  that  this  procedure  has  gen- 
erally been  effective. 

In  some  industries  there  is  no  need  for  the  con- 
certed action  of  a  large  number  of  producers  because 

'  The  Conxmisaion  's  italicg. 


COMPETITION  157 

there  is  only  one  producer,  who  has  survived  or  com- 
bined all  the  others.  Such  a  producer  is  said  to  have 
a  monopoly.  A  business  unit  might  be  organized 
for  the  purpose  of  producing  a  patented  article;  if 
no  other  company  had  the  right  to  use  the  patent, 
a  monopoly  would  be  inevitable.  But  there  are 
monopolies  that  have  developed  in  competitive 
industries  and  not  as  the  result  of  any  patent. 

Large-Scale  Production. — It  has  been  said  that 
there  is  a  tendency  toward  monopoly  even  in  a  com- 
petitive industry.  In  order  to  explain  this  seeming 
paradox,  it  will  be  helpful  to  consider  the  probable 
differences  between  the  costs  of  the  large  producers 
and  the  costs  of  the  small  producers.  If  Company 
A  manufactures  twice  as  much  product  as  Company 
B,  the  total  Raw-Material  cost  of  Company  A  will 
probably  be  twice  as  great  as  Company  B's  Raw- 
Material  cost.  The  Labor  cost  (Wages)  may  or 
may  not  be  twice  as  large  for  the  first  company.  It 
would  undoubtedly  take  more  laborers  to  double  the 
production,  but  if  it  did  not  take  twice  the  number, 
the  labor  cost  per  unit  of  product  would  be  less  for 
Company  A  than  for  Company  B.  Even  if  Company 
A  has  twice  as  large  a  payroll  as  Company  B,  the 
overhead  costs  and  all  the  costs  above  the  prime 
cost,  that  is,  above  materials  and  direct  wages, 
would  probably  be  very  little  greater  for  the  larger 
company.  Thus,  other  things  being  equal.  Company 
A  would  probably  have  a  smaller  cost  per  unit 
of  product  manufactured  than  Company  B.  More- 
over, even  if  Company  A's  production  were  in- 
creased so  that  a  larger  total  investment  and  a 


158      ECONOMICS  FOR  THE  ACCOUNTANT 

larger  overhead  were  needed  to  handle  the  increased 
output,  the  unit  cost,  nevertheless,  might  be  further 
decreased.  The  following  figures  will  help  to  clarify 
the  text: 


Company  A 

Company  B 

Production 

2,000,000  units 

1,000,000  units 

Raw-Material  Cost 

$2,000,000 
1,000,000 
1,000,000 

$1,000,000 

Labor  Cost   

500,000 

Overhead  Cost 

750,000 

Total  Cost 

$4,000,000 

$              2 

$2,250,000 

Cost  per  unit 

$              2.25 

The  unit  Raw  Material  and  Labor  costs  were  identi- 
cal but  the  Overhead  was  $0.50  for  Company  A  and 
$0.75  for  Company  B. 

What  has  been  described  in  the  foregoing  para- 
graph is  predicated  on  an  assumption  of  economic 
theory  known  as  the  law  of  increasing  returns.  As 
the  production  is  increased,  and  as  new  units  of 
labor  and  capital,  represented  by  capital  goods  and 
land,  are  added,  the  unit  cost  of  production  is 
decreased.  However,  in  almost  any  type  of  business, 
there  is  a  limit  beyond  which  additional  units  of 
labor  and  capital  goods  can  be  added  economically. 
When  the  addition  of  these  units  increases  the  pro- 
duction but  does  not  decrease  the  unit  cost,  or,  in 
other  words,  when  the  new  units  of  labor  and  capital 
just  pay  for  themselves,  the  law  of  constant  return 
is  said  to  be  operating.    There  might  come  a  time 


COMPETITION  159 

when  additional  units  of  labor  and  capital  would 
not  pay  for  themselves,  when  the  unit  cost  would  be 
increased  rather  than  decreased  as  a  result  of  the 
increased  production.  Then,  the  law  of  decreasing 
return  would  be  operating. 

It  is  generally  held  that  the  law  of  decreasing  or 
diminishing  return  begins  to  operate  sooner  in 
agriculture  and  in  the  extractive  industries  than  in 
manufacturing  or  in  marketing.  When  the  farmer 
first  hires  new  laborers  and  buys  additional  farm 
machinery,  the  product  will  probably  be  increased 
in  sufficient  quantities  to  pay  for  the  increased 
wages,  for  the  depreciation  on  the  new  machinery, 
and  the  interest  on  the  capital  used  to  obtain  the 
machinery  and  to  finance  the  extended  operations. 
However,  if  the  farmer  continues  to  add  more  labor, 
to  use  more  capital,  and  to  obtain  more  capital  goods, 
a  time  will  come  when  the  increased  quantities  pro- 
duced will  not  compensate  for  the  increased 
expenses,  such  as  wages,  depreciation,  and  interest. 
Under  such  circumstances,  the  law  of  diminishing 
return  has  begun  to  operate.  The  farmer,  then, 
looks  to  new  land  if  he  would  increase  his  product. 
In  agriculture,  this  law  has  resulted  in  a  limit  to 
*' intensive  cultivation"  and  has  encouraged  *' exten- 
sive cultivation." 

Inasmuch  as  the  operations  of  the  law  of  increas- 
ing return,  according  to  pure  economic  theory,  is 
supposed  to  apply  to  most  manufacturing  establish- 
ments, it  would  seem  that  the  largest  business  units 
would  have  the  lowest  cost.^    Futhermore,  since  the 

*  See  the  foregoing  paragraphs. 


160   ECONOMICS  FOR  THE  ACCOUNTANT 

large  low-cost  company  would  reinvest  its  profits 
and  expand,  its  costs  would  be  further  reduced.  If 
it  reduced  prices  so  as  to  obtain  new  customers,  it 
might  eventually  drive  out  all  competitors.  This 
explains  the  seeming  paradox  that  there  is  a  tend- 
ency toward  monopoly  even  in  competition. 

There  are  certain  interesting  qualifications  that 
might  be  appended  to  the  theory  advanced  in  the 
foregoing  paragraph.  There'  is  often  a  limit  to  the 
size  of  the  most  efficient  business  unit.  In  other 
words  the  law  of  increasing  returns  does  not  always 
operate  without  qualification  even  in  a  manufactur- 
ing industry.  Furthermore,  the  largest  company  does 
not  always  have  the  lowest  cost;  it  may  maintain  its 
relative  importance  in  the  industry  by  methods  that 
will  be  explained  in  subsequent  paragraphs.  Fin- 
ally, because  cost  is  dependent  on  many  different 
physical  and  psychological  factors,  a  low-cost  com- 
pany in  one  year  may  become  a  high-cost  company 
in  another  year. 

Obviously  the  relation  between  the  size  of  the 
business  unit  and  cost  would  be  different  for  dif- 
ferent industries.  Statistical  studies  will  have  to 
be  made,  however,  before  this  relation  can  be 
definitely  established.  The  unwillingness  of  pro- 
ducers to  i^eveal  their  costs,  as  well  as  the  great 
expense  involved  in  securing  them,  makes  such 
studies  practically  impossible  for  any  agency  other 
than  the  Federal  Government.  In  the  Federal  Trade 
Commission's  Report  on  Canned  Salmon,  December, 
1919,  it  was  shown  that  the  larger  plants  had  lower 
costs  than  the  smaller  plants  but  that  the  larger 


COMPETITION  161 

companies,  which  were  merely  combinations  of  a 
number  of  plants,  some  large  and  some  small,  had 
higher  costs  than  some  of  the  smaller  companies, 
which  might  have  had  only  one  large  plant.  It 
might  have  been  thought  that  the  large  company, 
which  was  merely  a  combination  of  small  plants, 
would  have  the  advantage  of  economy  in  buying 
materials  and  would  have  had  a  lower  General  and 
Administrative  Expense  per  unit  of  product. 

Unfair  Competition  and  the  Anti-Trust  Legisla- 
tion.— There  are  many  advantages  that  the  large 
company  has  even  though  some  of  the  smaller  com- 
panies may  have  lower  costs.  The  large  company 
with  great  capital  can  advertise  its  product  and 
obtain  a  profit,  that  does  not  result  from  reduced 
cost.*  Some  manufacturers,  who  are  not  nationally 
advertised,  have  to  sell  their  brands  at  prices  under 
the  prices  of  the  nationally  advertised  brands.  The 
large  company,  moreover,  can  stand  the  strain  of 
demoralized  prices  better  than  the  small  company. 
In  fact,  some  large  companies  have  been  known  to 
depress  their  prices  below  all  costs  for  a  period  in 
order  to  embarrass  their  weaker  and  smaller  com- 
petitors. The  large  companies  have  often  monopo- 
lized the  sources  of  supply  of  raw  materials,  or, 
through  control  of  transportation,  have  obviated 
competition.^  Secret  rebating  as  well  as  numerous 
other  unfair  methods  of  competition  have  also  led 
to  monopoly. 


*  See  page  145. 

"See  Summary  to  the  Federal  Trade  Commission's  Report  on  the 
Meat-Packing  Industry. 


162   ECONOMICS  FOR  THE  ACCOUNTANT 

When  industry  began  to  develop  in  the  United 
States  after  the  Civil  War,  producers  often  found  it 
advantageous  to  make  agreements  with  each  other 
rather  than  compete.  Moreover,  as  business  men 
came  to  realize  the  advantages  of  large-scale  produc- 
tion and  the  profits  to  be  made  by  eliminating  com- 
petition, they  began  to  combine  their  businesses.  The 
promoter's  profits  in  such  combinations  attracted  a 
certain  type  of  men  with  organizing  ability,  who 
attempted  to  combine  everything  there  was  to  be 
combined.  In  1890  Congress  enacted  the  Sherman 
Anti-Trust  Law,  which  made  any  monopoly,  at- 
tempted monopoly,  or  restraint  of  trade  illegal. 
By  ''restraint  of  trade"  was  probably  meant  any 
interference  with  competition.  Most  of  the  combina- 
tions had  been  affected  through  what  were  known 
as  trusts.  Every  stockholder  of  the  companies  com- 
bined had  surrendered  his  voting  power  to  a  group 
of  trustees,  who  gave  him  trust  certificates  in  return. 
The  holders  of  the  trust  certificates  received  the 
dividends,  but  the  control  was  vested  in  trustees, 
who  voted  the  stock.  The  Sherman  Law  declared 
these  "trusts"  illegal. 

Not  very  much  attention  was  given  to  this  law 
until  between  1900  and  1905,  when  a  large  number 
of  the  combinations  that  had  been  formed  began  to 
fail.^  These  failures  were  probably  due  to  the  fact 
that  competition  had  not  been  effectively  stifled  and 
that  the  combination  of  plants  and  companies  was 
often  less  efficient  than  the  separate  units  that  com- 

"  See  A.  S.  Dewing,  Corporate  Promotions  and  Reorganisation, 
Harvard  University  Press,  1914. 


COMPETITION  163 

posed  it.  These  failures  and  rising  prices  stirred  up 
feeling  against  combination  and  monopoly.  The  dis- 
solution of  the  Standard  Oil  Company  of  New 
Jersey  and  the  American  Tobacco  Company  in  1911 
sounded  a  note  of  warning  to  those  who  anticipated 
violating  the  Sherman  Law.  However,  it  is  often 
maintained,  and  with  good  reason,  that  the  dissolu- 
tion decrees  did  not  really  establish  competition. 
Although  the  Standard  Oil  Company  of  New  Jersey, 
which  had  controlled  the  other  Standard  Oil  com- 
panies through  the  ownership  of  majorities  of  their 
stocks,  was  dissolved,  the  original  stockholders  of 
the  Standard  Oil  Company  of  New  Jersey  were 
given,  as  individuals,  the  controlling  stocks  of  the 
various  Standard  Oil  companies.  Thus,  the  same 
families,  such  as  the  Eockef eller,  Harkness,  Flagler, 
Whitney  families,  etc.,  who  formerly  controlled  the 
Standard  Oil  Company  of  New  Jersey  and,  through 
it,  all  the  subsidiaries,  to-day  control  the  subsidiaries 
directly.  That  there  can  be  any  real  competition 
between  these  subsidiaries,  that  is,  between  the  dif- 
ferent Standard  Oil  companies,  seems  improbable. 
In  1914  the  Clayton  Act  and  the  Federal  Trade 
Commission  Act  were  passed  by  Congress  to  check 
incipient  monopoly.  The  Sherman  Law  had  only 
made  monopoly  or  attempted  monopoly  illegal.  The 
Clayton  Act  made  any  combination  that  *' substan- 
tially lessened  competition"  unlawful.  A  company, 
thus,  was  not  allowed  to  buy  the  stock  of  its  com- 
petitor, even  though  the  two  companies  together 
controlled  only  one  per  cent  of  the  total  production 
of  the  industry,  if  the  purchase  lessened  competition 


164      ECONOMICS  FOR  THE  ACCOUNTANT 

between  them.  Furthermore,  price  determination  as 
between  different  purchasers  was  declared  illegal. 
The  Federal  Trade  Commission  Act  created  a  body 
that  was  given  authority  to  declare  unfair  methods 
of  competition  unlawful.  It  was  believed  that  secret 
rebating,  misbranding,  price  discrimination,  and 
other  unfair  methods  of  competition  would  enable 
companies  that  used  them  to  crush  their  competitors. 
Therefore,  the  Federal  Trade  Commission  is  author- 
ized to  investigate  all  suspicious  trade  practices  and 
to  decide,  subject  to  later  revision  by  the  courts, 
what  methods  of  competition  are  unfair  and  should 
be  declared  unlawful. 


CHAPTER  XIV 

TAXATION 

Man's  Political  Relations. — In  all  of  the  foregoing 
chapters  man  has  been  considered  in  his  economic 
relations  only.  Because  all  are  consumers,  and  in 
order  to  be  consumers  must  give  aid  in  production 
or  receive  support  from  those  who  do,  all  have  an 
economic  relation  and  are  a  part  of  the  economic 
organization  of  society.  But  everyone  also  has  a 
political  relation  and  is  a  part  of  the  state.  For- 
merly, there  were  two  classes:  the  governors  and 
the  governed;  but  in  modern  democracy  every  man 
is  supposed  to  have  something  to  say  about  how  he 
is  governed.  The  government,  therefore,  is  created 
in  the  state  and  by  the  people  of  the  state  to  manage 
its  affairs. 

The  student  of  economics  will  readily  see  the  need 
of  government.  Competition  presupposes  rivalries, 
conflicts  of  interest,  and  cross-purposes  in  the  recon- 
ciliation of  which  a  government  and  governmental 
machinery  are  necessary.  Furthermore,  the  govern- 
ment is  needed  to  do  certain  definite  things  that 
individuals  could  not  or  would  not  do,  as  for  example 
public-health  service.  Finally,  a  government  has 
always  been  expected  to  protect  its  people  from  the 
aggressions  of  other  peoples. 
It  was  stated  in  Chapter  I  that  a  German  econ- 

165 


166   ECONOMICS  FOR  THE  ACCOUNTANT 

omist  had  criticised  American  economists  because 
they  do  not  pay  sufficient  attention  to  the  relation 
of  the  state  to  man's  economic  welfare.  Most 
American  and  English  economists  have  believed  for 
many  years  in  a  laissez-faire  policy  for  the  govern- 
ment. In  other  words  they  have  believed  that  the 
government  should  interfere  as  little  as  possible 
with  men  in  their  economic  activities.  Moreover, 
many  of  them  have  believed  that  the  government 
should  do  as  little  as  possible.  It  will  be  shown  that 
these  theories  of  government  have  an  important 
bearing  on  the  problem  of  taxation. 

The  Purposes  of  Taxation. — ^It  is  evident  that  if 
a  government  does  anything  at  all,  it  must  have 
funds.  These  funds  are  usually  obtained  through 
taxation.^  C.  F.  Bastable,  the  English  economist, 
defines  a  tax  as  *'a  compulsory  contribution  of  the 
wealth  of  a  person  or  body  of  persons  for  the  service 
of  the  public  power."  Those  who  think  that  the 
government  should  do  as  little  as  possible  would 
probably  believe  in  the  lightest  taxes  possible.  They 
would  be  inclined  to  oppose  any  taxes  but  those 
absolutely  necessary  for  the  simplest  kind  of  govern- 
mental machinery.  For  them  the  only  purpose  of 
a  tax  would  be  the  financial  support  of  the  govern- 
ment. 

A  tax  may  have  one  or  two  other  purposes  than 
the  one  mentioned.  (1)  Certain  forms  of  taxation 
are   often  proposed  as   methods   of  redistributing 

*  These  funds,  however,  might  be  obtained  from  rents  paid  by  those 
who  lease  the  public  domain  or  government  lands,  or  they  might  be 
secured  by  the  government's  business  activities,  such  as  running  the 
railroads,  etc. 


TAXATION  167 

wealth.  The  inheritance  tax,  for  example,  might  be 
used  to  take  from  those  who  have  too  much  and  to 
help  those  who  have  too  little.  Obviously,  if  the 
government,  Federal  or  State,  imposed  a  larger  tax 
on  inheritances,  the  proceeds  would  be  sufficient  to 
obviate  certain  other  taxes,  which  might  be  paid  by 
those  who  can  less  well  afford  to  contribute  to  the 
state's  support  than  the  beneficiaries  of  inheritances. 
(2)  Some  taxes  have  been  proposed  primarily  for 
the  accomplishment  of  some  especial  purpose.  The 
tax  on  State  banknotes  and  on  oleomargarine  were 
imposed  primarily  to  obviate  their  existence.  The 
taxes  on  whiskey  and  tobacco  may  have  had  some- 
what the  same  purpose,  but  they  were  also  used 
for  the  revenue  they  yielded.  This  was  also  true  of 
the  protective  tariff,  which  kept  out  certain  foreign 
products  and  stimulated  American  industries,  but 
which  was  also  an  important  revenue-yielding  tax. 

Most  fiscal  systems  employed  by  governments 
to-day  include  all  kinds  of  taxes,  most  of  which 
have  been  imposed  for  more  than  one  reason.  Even 
those  taxes,  that  have  been  levied  primarily  for 
revenue,  have  often  been  imposed  in  such  a  way  as 
to  put  the  least  burden  on  the  poor  and  heavier 
burdens  on  those  who  could  better  afford  to  bear 
them..  This  method  of  imposing  taxation,  however, 
has  not  been  evolved  primarily  for  the  purpose  of 
redistributing  wealth  but  because  taxation  seems 
less  burdensome  when  those  who  can  best  afford  to 
pay  are  taxed  most. 

The  Single  Tax. — The  single  tax  has  been  pro- 
posed by  social  reformers  as  a  means  of  redistribut- 


168   ECONOMICS  FOR  THE  ACCOUNTANT 

ing  wealth.  The  name  of  Henry  George  usually  has 
been  associated  with  this  tax  in  the  United  States 
but  the  French  Physiocrats  had  somewhat  the  same 
idea  back  in  the  eighteenth  century.  The  single  tax, 
as  conceived  by  Henry  George  and  the  Physiocrats, 
was  to  be  a  tax  on  land  and  rent.  All  of  the  state's 
revenues  were  to  be  obtained  from  this  tax.  There 
are  probably  two  considerations  that  led  to  this  pro- 
posal: first,  land  is  not  produced  by  man's  efforts 
and  rent  from  the  use  of  land  seems  unjustified; 
second,  land  increases  in  value  because  of  the  growth 
of  population  and  through  no  effort  on  the  part  of 
the  landowner.  Even  though  there  might  seem  to 
be  no  justification  for  allowing  a  man  to  claim  a 
piece  of  land  as  his  own,  because  he  did  not  produce 
it,  it  is  clear  that  after  the  first  transfer,  it  would  be 
easy  to  justify  ownership  and  rent,  especially  if  the 
purchaser  had  saved  out  of  his  wages  the  capital 
necessary  to  make  the  purchase.  Moreover,  the  rent 
demanded  by  the  first  owner  is  not  large  pay  for  the 
hardships  of  frontier  life.  The  taxation  of  unearned 
increments  in  land  values,  which  is  being  developed 
particularly  in  municipal  finance,  meets  the  second 
problem  of  the  single  taxer.  Furthermore,  the 
income  and  profit  taxes  are  probably  the  most  effec- 
tive way  of  reaching  this  source  of  taxation.  It 
should  be  noted  that  there  are  many  unearned 
increments  other  than  in  land  values,  as  for  example, 
the  appreciation  in  the  value  of  other  capital  goods, 
inheritances,  and  other  kinds  of  profits.^  The  single 
tax  would  neglect  all  these,  and  would  give  undue 

"  See  Chapter  XII. 


TAXATION  169 

emphasis  to  unearned  increments  in  land  values. 
This  tax  has  never  been  tried  on  a  large  scale,  and 
has  probably  even  lost  vogue  as  a  method  of  social 
reform  since  the  spread  of  Socialism. 

It  is  doubtful  whether  taxation  has  ever  been  used 
to  any  great  extent  merely  for  the  redistribution  of 
wealth.  A  government  needs  funds  and  taxes  the 
citizens  or  the  institutions  of  the  state  in  order  to 
obtain  them.  In  imposing  taxes,  it  may  consider  on 
whom  the  taxes  will  fall,  that  is,  who  actually  pays 
them,  and  it  may  attempt  to  have  them  fall  most 
heavily  on  those  who  can  best  afford  to  pay  them. 
If  this  principle  is  carried  very  far,  and  if  the  gov- 
ernment uses  the  proceeds  from  such  taxes  to 
improve  the  condition  of  the  poor,  taxation  is 
incidentally  being  used  to  redistribute  wealth. 

The  Shifting  and  Incidence  of  Taxation. — The  fact 
that  many  taxes  that  seem  to  be  paid  by  one  class 
are  really  paid  by  another  has  stimulated  the  econ- 
omist's interest  in  the  "shifting  and  incidence"  of 
taxation,  or  in  how  a  tax  may  be  shifted  by  those  on 
whom  it  is  imposed  to  others  on  whom  it  falls 
(incidence).  It  has  been  explained  that  a  tax  on 
imports  will  be  shifted  by  the  importer  to  the  con- 
sumer. If  an  article  were  produced  in  the  United 
States  at  costs  ranging  from  $4.50  to  $5.20  and  sold 
at  about  $5.10,  the  same  article  produced  in  Ger- 
many at  costs  from  $3.50  to  $4.00  would,  at  a  price  of 
about  $4.00,  including  freight,  supplant  a  part  or 
all  of  our  American-made  product.  If  a  tariff  of  a 
dollar  were  imposed,  the  German  and  the  American 
product  would  compete.    The  importer  would  pay 


170      ECONOMICS  FOR  THE  ACCOUNTANT 

$4.00  for  the  German  product  and  $1.00  tariff,  but 
he  would  be  able  to  charge  the  consumer  about  $5.10. 
Thus,  he  would  shift  the  tax  to  the  consumer.  If 
the  article  were  not  manufactured  in  the  United 
States,  the  importer  would  be  able  to  shift  the  tax 
and  probably  be  able  to  include  an  even  greater 
margin  of  profit  in  his  selling  price. 

The  Income  and  Profit  Taxes. — Most  of  the  rev- 
enue of  our  Federal  Government  has  been  derived 
from  the  income  tax  since  1916.  Congress  had  estab- 
lished an  income  tax  in  1894  but  the  Supreme  Court 
had  declared  it  unconstitutional.  An  amendment  to 
the  Constitution  allowing  Congress  to  levy  an  income 
tax  was  passed  in  1909  and  ratified  by  the  necessary 
number  of  States  in  1913.  The  Act  of  1913  imposed 
an  ordinary  tax  of  one  per  cent  on  all  incomes  over 
$3,000  and  $4,000  for  a  married  couple,  and  a 
graduated  surtax,  ranging  from  one  to  six  per  cent, 
on  incomes  over  $20,000.  The  highest  rate  applied  to 
incomes  over  $500,000.  The  ordinary  tax  was  col- 
lected from  all  corporations;  the  stockholders  as 
individuals,  thus,  were  exempted  from  paying  it. 
In  1916  the  ordinary  rate  was  increased  to  two  per 
cent  and  the  rates  of  the  surtax  were  fixed  at  frofa 
1  to  13  per  cent. 

When  the  United  States  entered  the  War  in  1917, 
the  War  Revenue  Act  revised  the  income  tax.  The 
normal  rates  were  doubled  and  a  four  per  cent  tax 
was  levied  on  corporations.  In  addition  to  the  sur- 
tax, 1  to  13  per  cent,  a  war  surtax  on  incomes  over 
$5,000  was  imposed  with  rates  from  1  to  50  per  cent. 
In  1919  the  income-tax  law  was  revised  so  there  was 


TAXATION  171 

just  one  set  of  normal  and  surtax  rates.  Under  this 
law  of  1919,  incomes  over  $1,000,  or  $2,000  for  a 
married  couple,  were  taxed.  On  incomes  from  $1,000 
to  $5,000  the  normal  tax  was  6  per  cent,  and  on 
incomes  over  $5,000  it  was  12  per  cent.  The  surtax, 
which  was  imposed  only  on  incomes  over  $5,000, 
ranged  from  1  per  cent  up  to  65  per  cent.  The  last 
rate  applied  to  any  income  over  $1,000,000. 

The  great  profits  due  to  the  high  prices,  which 
prevailed  during  the  War,  were  taxed  by  what  is 
kno^Yn  as  the  excess-profits  tax.  All  businesses,  which 
earned  a  gross  profit,  or  interest  plus  profit,  in  excess 
of  a  certain  percentage  of  the  capital  invested,  fixed 
at  eight  per  cent,  paid  taxes  varying  from  20  to  60 
per  cent  according  to  the  rates  of  gross  profit  earned 
on  investment.  Thus,  if  a  business  earned  anywhere 
from  8  to  15  per  cent  gross  profit,  it  paid  a  tax  of 
20  per  cent;  if  the  gross  profit  was  from  15  to  20 
per  cent,  it  paid  a  tax  of  25  per  cent,  etc. 

In  1919  this  excess-profits  tax  was  revised.  A  new 
tax,  known  as  the  war-profits  tax,  was  imposed  as 
an  alternative.  This  tax  was  fixed  at  80  per  cent  of 
the  amount  of  difference  between  the  income  of  a 
pre-war  period  and  of  the  year  for  which  the  tax  was 
levied.  The  excess-profits  and  the  war-profits  taxes 
were  both  to  be  computed,  and  whichever  was  larger 
was  to  be  paid. 

Although  the  income  tax  was  levied  on  incomes, 
which  were  received  as  wages,  rent,  interest,  or 
profit,  the  profits  taxes  were  levied  directly  on  the 
entrepreneur's  share.  The  incidence  of  a  tax  on 
profits  is  a  problem  of  great  interest  to  both  the 


172   ECONOMICS  FOR  THE  ACCOUNTANT 

economist  and  the  accountant.  It  has  been  shown 
that  in  a  normal  period  price  is  fixed  at  the  bnlk- 
line  producer's  cost.  The  hulk-line  producer,  how- 
ever, just  receives  interest  hut  earns  no  profit;  he, 
therefore,  pays  no  tax.  The  producers  with  costs 
lower  than  that  of  the  hulk-line  man  must  pay  the 
tax  out  of  the  profit  that  competition  would  allow 
them,  if  it  he  assumed  that  they  cannot  lift  the  price 
above  the  bulk-line  cost.  Thus,  price  would  not  be 
affected  and  the  producer,  not  the  consumer,  would 
be  forced  to  shoulder  the  tax. 

In  a  period  of  inflated  prices,  when  price  is  far 
above  the  bulk-line  costs,  all  producers,  even  the 
highest-cost  producers,  would  make  a  profit  and  have 
a  tax  to  pay.  The  high-cost  producers,  as  well  as 
the  low-cost  producers,  would  be  able  to  shift  price 
up  so  to  cover  the  profits  tax  or  a  part  of  it.  There- 
fore, during  the  War,  when  the  demand  justified  any 
prices  and  when  prices  were  high  above  all  costs, 
the  profit  taxes  were  probably  shifted  to  the  con- 
sumer. The  fact  that  profits  taxes  were  shifted  to 
the  consumer  during  the  War  was  used  against  them 
by  many  who  argued  for  a  sales  tax.  The  difficulty 
of  determining  the  profit  for  business  organizations, 
the  publicity  it  gave  to  war  profits,  and  the  burden 
it  imposed  on  entrepreneurs  were  the  real  motives 
that  were  behind  the  opposition  to  the  income  and 
profit  taxes.  The  sales  tax  can  be  shifted  to  the 
consumer  in  normal  as  well  as  abnormal  times  but 
the  possibility  of  shifting  a  tax  on  profits  is  far  more 
limited.  The  marginal,  as  well  as  the  lower-cost, 
producers  will  pay  the  sales  tax;  they  will  add  it  to 


TAXATION  173 

cost  and  probably  succeed  in  sliifting  it  to  the  con- 
sumer. 

There  is  an  interesting  question  as  to  whether  the 
accountant  sliould  include  the  tax  on  profits  in  cost. 
Obviously  the  bulk-line  producer  would  have  no  such 
tax  in  his  cost,  because  he  would  have  none  to  pay. 
Furthermore,  the  tax  could  not  be  included  in  cost 
when  profit  is  being  determined,  because  its  inclu- 
sion would  presuppose  that  profit  was  already 
determined.'  It  is  a  tax  based  on  profit.  However, 
after  it  is  determined,  that  is,  after  price  is  fixed, 
it  might  very  well  be  added  to  the  other  costs  or 
monetary  sacrifices  of  the  entrepreneur.  But  if  the 
cost  is  to  be  used  by  the  entrepreneur  merely  as  a 
basis  for  fixing  a  price,  it  should  not  include  the 
profit  tax.  Furthermore,  in  determining  cost  for 
the  purpose  of  computing  the  profit  tax  to  be  paid, 
it  would  be  absurd  and  logically  impossible  to 
attempt  to  include  such  a  tax.* 

'See  Appendix  II. 
*  See  Appendix  II. 


APPENDICES 


APPENDIX  I 

INTEREST  AS  A  PART  OP   COST 

The  problem  of  whether  interest  should  be 
included  in  cost  is  much  debated  by  accountants, 
but  the  solution  of  this  problem  is  so  dependent 
upon  a  knowledge  of  economic  theory  that  much 
tliat  has  been  written  and  said  is  either  illogical  or 
irrelevant.  This  question  has  been  referred  to  in  a 
number  of  places  in  this  book,  but  it  seems  advisable 
to  set  forth  a  complete  discussion  of  the  problem  in 
this  appendix. 

It  has  been  explained  that  the  accountant  is 
working  for  the  entrepreneur  and  that  accounting 
cost  is  practically  the  entrepreneur's  cost.^  Just 
who  the  entrepreneur  is  and  what  he  does  has  also 
been  discussed  in  detail  on  page  137.  In  a  corpora- 
tion, the  most  common  form  of  business  organization, 
the  common  stockholders  are  the  entrepreneur  and 
in  a  single  proprietorship  or  partnership,  the  pro- 
prietor or  partners.  The  entrepreneur  has  the  vot- 
ing control  and  he  is  owner  of  the  capital  goods  and 
product.  The  entrepreneur  may  or  may  not  be  the 
capitalist.  The  capitalist  supplies  the  capital,  which 
is  defined  as  ^postponed  claims  on  consumption  goods, 
expressed  in  terms  of  money.     The  entrepreneur 

*  Accounting  costg  are  actually  the  entrepreneur's  costs  that  can  be 
established  before  sale. 

177 


178      ECONOMICS  FOR  THE  ACCOUNTANT 

takes  these  postponed  claims  and  uses  them  for 
expenses  or  transfers  them  into  capital  goods,  which 
are  defined  as  goods  used  in  the  production  of  other 
goods.  Although  it  should  be  noted  that  in  prac- 
tically all  corporations  the  common  stockholders 
supply  capital,  when  they  buy  their  common  stock, 
the  common  stockholder  can  be  a  pure  entrepreneur 
and  have  no  dollar  of  invested  capital  in  the  busi- 
ness.^ Furthermore,  even  though  the  function  of  the 
entrepreneur  and  the  function  of  capitalist  may  be 
embodied  in  the  same  person,  they  are,  nevertheless, 
separate  functions.  The  shoemaker  described  on 
page  83  was  entrepreneur,  capitalist,  and  laborer. 
Not  only  should  these  functions  be  distinguished  but 
the  returns  received  should  be  differentiated.  The 
shoemaker  receives  profit  as  entrepreneur,  interest 
as  capitalist,  and  wages  as  laborer. 

It  was  explained  on  page  83  that  the  entrepeneur  's 
sacrifies  in  his  other  capacities  are  as  much  a  part 
of  his  costs  as  his  actual  monetary  expenditures. 
Thus,  the  entrepreneur's  costs  include  an  allowance 
for  himself  as  laborer,  if  he  works,  and  interest  on 
his  own  capital  as  well  as  his  actual  monetary  pay- 
ments to  hired  laborers,  to  the  bankers,  and  to  the 
entrepreneurs,  who  furnished  him  with  raw  ma- 
terials. 

There  are  certain  sacrifices  made  by  the  entre- 
preneur, as  entrepreneur,  but  such  sacrifices  are  not 
included  or  compensated  for  in  cost,  even  if  they 
could  be  measured  in  money.  Thus,  the  undertaker 
may  be  making  a  sacrifice  in  engaging  in  his  profes- 

^'See  page  137. 


INTEREST  AS  A  PART  OF  COST  179 

sion,  but  lie  makes  this  sacrifice  as  entrepreneur  and 
receives  his  reward  in  profit,  which  theoretically 
would  be  greater  because  competition  would  prob- 
ably be  less  keen.  Even  if  the  distaste  of  each  par- 
ticular entrepreneur  could  be  measured  in  terms  of 
money,  it  would  not  be  a  legitimate  part  of  the 
entrepreneur's  cost.  Engaging  in  a  distasteful 
occupation  is  one  of  the  functions  of  an  entrepreneur 
who  directs  funerals,  and  his  profit  is  the  payment 
for  this  among  other  things.  The  undertaker's  dis- 
taste is  his  sacrifice  as  entrepreneur,  not  his  sacrifice 
as  laborer  or  as  capitalist.  Now,  if  the  entrepreneur 
receives  any  return  in  his  capacity  of  entrepreneur, 
it  is  his  profit  and  not  his  cost. 

Obviously  if  the  entrepreneur's  cost  is  being  con- 
sidered, his  payments  of  interest  to  outside  capi- 
talists and  an  interest  charge  for  his  own  capital 
must  be  included  in  his  entrepreneurial  cost.  He, 
as  entrepreneur,  owes  himself  as  capitalist  inter- 
est just  in  the  same  way  that  he  owes  himself  a 
salary  as  laborer,  if  he  works.  It  might  be  urged 
that  an  entrepreneur  must  have  capital  in  order  to 
be  an  entrepreneur,  and  that  the  interest  he  receives 
is  no  different  from  profit  in  that  it  is  a  return  for 
one  of  his  necessary  entrepreneurial  functions.  But 
it  was  explained  on  page  137  that  there  can  be  a  pure 
entrepreneur  and  it  must  be  realized  that  inventors 
are  often  pure  entrepreneurs  when  they  take  the 
common  stock  of  the  enterprise  and  sell  preferred 
stock  to  outside  capitalists.  That  the  entrepreneur 
of  a  corporation,  the  stockholder,  is  usually  both 
entrepreneur  and  capitalist  has  led  most  accountants 


180      ECONOMICS  FOR  THE  ACCOUNTANT 

to  insist  that  their  return  cannot  be  subdivided  into 
interest  and  profit.  However,  some  members  of  the 
profession  realize  that  interest  actually  paid  on 
short-term  loans,  on  notes,  or  on  bonds  are  actual 
expense  in  the  same  way  that  wages  paid  to  laborers 
and  rent  are  expense.  For  another  reason  some 
accountants  include  interest  on  short-term  notes 
although  interest  on  capital,  borrowed  for  longer 
than  a  year,  is  excluded.^ 

There  is  one  argument  of  some  interest  for  includ- 
ing interest  actually  payable  in  cost  and  excluding 
interest  on  the  stockholders '  investment :  the  interest 
to  outside  capitalists  has  to  be  paid,  whereas  the 
interest  on  the  stockholders'  capital  legally  need 
never  be  paid.  Although  it  will  be  shown  that  this 
is  no  basis  for  the  distinction  between  what  is  cost 
and  what  is  not  cost,  the  same  argument  can  be 
used  against  the  inclusion  of  Salaries  and  even  of 
Depreciation  in  cost.  Although  Depreciation  repre- 
sents a  part  of  what  was  spent,  legally,  it  need  not 
be  set  aside.  It  represents  an  allowance  to  take  care 
of  the  capital  expended  in  the  purchase  of  the  fixed- 
capital  goods  (depreciated)  but  if  this  capital,  or 
a  part  of  it,  was  supplied  by  the  stockholders,  the 
depreciation  allowance  is  no  more  their  obligation 
than  the  interest  payment.  The  capital  could  not  be 
replaced  if  Depreciation  were  not  allowed  in  cost 
or  deducted  from  profits,  but  the  business  might  go 
on  nevertheless;  moreover,  the  entrepreneur-capi- 
talist would  hardly  be  willing  to  continue  if  he  could 
not  even  make  a  sufficient  Gross  Profit,  or  interest 

•See  pages  127  and  128. 


INTEREST  AS  A  PART  OF  COST  181 

pins  profit,  to  cover  an  interest  return.  In  tlie  final 
analysis,  however,  entrepreneur's  cost  is  not  a 
matter  of  law  or  judicial  decision;  it  is  a  total  of 
expenditures  made  to  others  and  allowances  for 
sacrifices  made  by  the  entrepreneur  in  his  other 
capacities. 

It  might  be  asked  what  allowance  is  to  be  made 
the  entrepreneur,  if  he  works.  The  answer  seems 
simple  enough:  wiiat  he  is  worth.  It,  then,  might 
be  argued  that  a  laborer  may  get  less  than  he  is 
worth,  and  that  the  laborer's  sacrifice  is  not  cost. 
True,  but  the  entrepreneur  is  in  a  strategic  position 
and  he  can  insist  upon  his  worth  in  his  bargain  with 
himself.  Furthermore,  the  accountant  must  give 
him  his  worth  because  the  accounting  statement  is 
made  for  the  entrepreneur.  It  may  be  recognized 
that  the  allowance  of  salary  for  entrepreneurs  com- 
mensurate with  their  worth  is  the  accountant 's  tacit 
assumption  of  the  productivity  theory."*  It  is  impor- 
tant to  note  that  the  accountant  is  not  interested  in 
the  laborers '  sacrifices  except  when  the  laborer  hap- 
pens to  be  the  entrepreneur. 

It  seems  indisputable,  then,  that  if  it  can  be 
assumed  that  the  accountant  is  determining  the 
entrepreneur's  cost,  interest  as  well  as  salaries  for 
stockholders  who  work  must  be  included.  However, 
the  reasons  for  assuming  that  accounting  cost  must 
coincide  with  entrepreneur's  cost  have  not  been  fully 
presented.  Before  these  reasons  can  be  compre- 
hended, a  restatement  of  the  purposes  of  cost  is 
necessary.    There  are  four  principal  needs  of  know- 

*  See  Chapter  IV. 


182   ECONOMICS  FOR  THE  ACCOUNTANT 

ing  unit  costs  of  producing  the  different  sizes  and 
grades  of  commodities  handled:  (1)  for  fixing  sell- 
ing prices;  (2)  for  determining  the  different  profits 
on  the  different  commodities,  after  they  are  sold; 
(3)  for  comparing  the  itemized  costs  of  different 
plants  and  for  different  years,  etc.;  and  (4)  for  valu- 
ing inventories. 

It  has  been  explained  at  great  length  that  seldom 
does  the  entrepreneur  sit  at  his  desk  and  fix  a  price; 
he  attempts  to  get  the  best  price  he  can.  However, 
there  are  two  particular  reasons  for  knowing  the 
unit  costs.  When  prices  are  falling  or  where  com- 
petition is  very  keen,  the  entrepreneur  wants  to 
know  cost  in  order  to  know  the  lowest  possible  price 
that  will  not  result  in  a  loss.  Obviously,  for  this 
purpose  interest  actually  paid  or  payable  should  be 
considered,  for  even  if  he  received  cost  without  any 
interest,  he  might  be  losing  money  because  he  might 
have  to  pay  bond  interest,  interest  to  the  banks,  and 
probably  even  preferred-stock  dividends.  Further- 
more, even  if  he  included  interest  paid  but  did  not 
include  interest  on  his  own  capital  he  would  not  be 
receiving  a  price  that  would  allow  him  to  be  break- 
ing even,  because  he  would  be  unpaid  as  capitalist. 
Furthermore,  if  interest  is  excluded  when  competi- 
tion is  very  keen,  one  entrepreneur  may  believe  that 
he  has  a  lower  cost  than  the  others,  whereas  his 
lower  labor  cost,  for  example,  may  be  due  to  a 
greater  use  of  machinery,  which  may  have  been 
financed  by  outside  capital  and  require  actual  inter- 
est payments. 

The  accountant  may  insist  that  he  takes  these 


INTEREST  AS  A  PART  OF  COST  183 

things  into  consideration  even  though  he  does  not 
consider  them  in  connection  with  cost.  Some 
accountants  have  so  limited  the  conception  of  pro- 
duction cost  that  they  do  not  even  consider  inventory 
adjustments,  General  and  Administrative  Expense, 
or  Selling  Expense.  Obviously,  for  the  use  of  cost 
in  connection  with  price,  these  considerations  must 
not  be  neglected.  The  Cost  of  Sales,  rather  than  the 
Cost  of  Production,  that  is.  Cost  of  Production,  plus 
the  first  Inventory,  minus  the  last  Inventory,  plus 
the  General  and  Administrative  Expense,  plus  Sell- 
ing Expense,  must  be  considered  when  using  cost  as 
a  basis  for  price  quotation.  The  accountants  who 
oppose  the  inclusion  of  interest  in  the  Cost  of  Sales 
would  insist  that  when  selling  price  is  to  be  con- 
sidered, some  allowance  can  be  made  for  the  invest- 
ment, but  obviously  the  best  way  to  treat  this  invest- 
ment is  to  include  interest  in  cost.  Furthermore, 
this  allowance  is  usually  supposed  by  accountants 
to  be  a  combination  of  interest  and  profit,  and  the 
difference  between  price  and  cost,  minus  interest,  is 
often  called  return  on  investment.  This  treatment  of 
interest  and  profit  is  based  on  a  misconception  of  the 
nature  of  these  two  shares.  Profit  is  not  determined 
until  the  sale  is  made,  but  interest  is  a  cost  the 
moment  capital  is  injected  into  the  business  unit. 
The  accountant  may  object,  and  urge  that  interest  is 
not  always  realized.  Interest  is  not  ''realized"  any 
more  than  wages  are  "realized";  both  wages  and 
interest  are  costs  even  if  the  goods  are  never  sold. 
Profit  is  the  only  share  that  is  determined  by  sale.' 

•  See  Appendix  II. 


184      ECONOMICS  FOR  THE  ACCOUNTANT 

The  possibility  of  arriving  at  an  actual  Cost  of 
Sales  on  wliicli  price  can  be  based  may  be  questioned, 
inasmuch  as  goods  are  being  sold  constantly  and  an 
accurate  Cost  of  Sales  would  be  difficult  to  determine 
until  the  end  of  the  year.  However,  even  if  only  the 
Cost  of  Sales  of  the  past  year  is  available,  it 
furnishes  a  basis  for  estimating  the  probable  present 
cost. 

The  second  reason  given  for  cost  analysis  was  the 
necessity  for  determining  the  different  profits  on  the 
different  commodities  manufactured.  The  efficient 
general  manager  needs  to  know  on  which  commodity, 
and  even  on  which  size  or  grade  of  the  different  com- 
modities, he  has  realized  the  least  profit.  The  sales 
policy  and  the  emphasis  in  manufacturing  may  be 
determined  by  the  different  margins  of  profit  re- 
alized. For  this  purpose  it  is  obvious  that  the 
investment  must  be  considered.  If  one  commodity 
shows  a  lower  cost  than  another,  it  may  be  due  to 
the  larger  amount  of  capital  invested  in  the  machin- 
ery used  in  producing  the  apparently  cheaper  com- 
modity. The  accountant  may  believe  that  if  interest 
is  excluded,  the  gross  margins  between  the  prices 
and  the  computed  costs,  that  is,  interest  and  profit, 
can  be  measured  on  the  investments  in  order  to 
determine  the  profitableness  of  the  various  com- 
modities. However,  this  involves  a  computation  of 
investment,  and  furnishes  a  useful  basis  for  compari- 
son, although  it  too  often  assumes  that  profit  bears 
a  fixed  relation  to  investment.^  Too  many  account- 
ants neglect  the  matter  of  investment  altogether,  and 

•  See  Chapter  XII. 


INTEREST  AS  A  PART  OF  COST  185 

believe  tliat  a  comparison  of  costs,  excluding  inter- 
est, is  all  that  is  needed.  The  exclusion  of  interest 
from  cost  has  led  to  this  belief. 

The  third  reason  for  cost  analysis,  for  a  comparison 
of  the  costs  of  different  plants,  is  often  admitted  as 
a  good  reason  for  including  interest  in  cost.  If  the 
costs  of  various  plants  are  being  compared,  some  of 
which  pay  rent,  an  item  of  cost,  and  some  of  which 
are  owned,  those  that  are  owned  will  seem  to  have 
much  lower  costs  than  those  that  pay  rent,  whereas 
the  efficiencies  of  the  apparently  high-cost  plants  may 
actually  be  greater  than  those  of  the  apparently  low- 
cost  plants. 

The  fourth  purpose  of  cost  accounting  is  probably 
the  most  important  from  the  accountant's  point  of 
view.  The  accountant  maintains  that  in  computing 
profit,  the  adjusting  inventories  of  finished  goods 
should  be  valued  at  cost.'^ 

Therefore,  the  cost  of  the  finished  goods  has  to  be 
determined  before  they  can  be  valued  in  the  closing 
inventory.  Some  usually  thoughtful  accountants 
argue  that  the  inclusion  of  interest  in  cost  involves 
an  interest  charge  in  the  inventories.  The  inventories 
are  not  sold,  they  maintain,  and  therefore  they 
believe  that  interest  is  not  realized.  But  interest 
may  be  actually  paid,  or  be  payable,  and,  if  not 
actually  paid,  sacrificed.  The  labor  cost  embodied  in 
the  inventories  is  not  ''realized"  until  they  are  sold, 
but  no  one  ever  doubts  but  that  labor  is  a  cost. 
Neither  wages  nor  interest  need  to  be  "realized"  in 
order  to  be  costs;  profit  is  the  only  share  that  is 

'  See  page  133. 


186   ECONOMICS  FOR  THE  ACCOUNTANT 

determined  by  price  and  the  market,  and  profit  is  the 
only  share  that  is  "realized"  by  the  entrepreneur  in 
the  sense  that  these  accountants  use  the  word.  True, 
the  interest  may  not  be  earned  or  paid,  but  that  is 
also  true  of  the  wages.  If  interest  is  logically  a  part 
of  cost,  it  is  highly  illogical  to  object  to  its  inclusion 
in  inventories,  if  they  are  to  be  valued  at  cost.  To 
object  to  interest,  assuming  that  it  is  logically  a  cost 
item,  because  it  inflates  cost  or  the  valuation  of  the 
inventories,  is  like  arguing  that  wages  or  Deprecia- 
tion should  not  be  considered  cost  items  because 
they  increase  costs. 

It  seems  evident  that  it  is  the  pure  entrepreneur's 
cost  that  the  accountant  is  determining.  If  the 
accountant  refuses  to  admit  this,  he  is  put  in  the 
position  where  he  must  consider  his  statements  com- 
piled for  the  stockholders,  bondliolders,  and  banks. 
Obviously,  he  is  not  making  his  statements  for  any 
one  other  than  the  common  stockholders.  On  the 
Balance  Sheet,  for  example,  the  Surplus  is  not  de- 
scribed as  the  common  stockholders'  Surplus,  but  it 
so  evidently  belongs  to  them  that  no  specific  mention 
is  necessary.  Every  accounting  statement  is  made  for 
the  common  stockholders,  who  may  or  may  not  be 
entrepreneur-capitalist,  but  who  are  always  entre- 
preneur. If  it  is  contended  that  the  entrepreneur  is 
seldom  a  pure  entrepreneur  and  is  usually  entre- 
preneur-capitalist, cost  without  interest  would  not 
be  giving  the  entrepreneur-capitalist  the  same  con- 
sideration accorded  the  outside  capitalists.  Thus, 
the  exclusion  of  all  interest  to  banks,  bondholders, 
and  stockholders  would  involve  an  illogical  grouping 


INTEREST  AS  A  PART  OF  COST  187 

of  partners,  or  stockholders,  and  creditors,  the  banks 
and  bondliolders,  as  well  as  a  confusion  of  profit  and 
interest,  and  the  inclusion  of  interest  actually  paid, 
along  with  the  exclusion  of  interest  on  the  stock- 
holders' capital,  would  be  treating  the  capitalists, 
for  whom  the  statement  is  made,  with  less  considera- 
tion than  the  outside  capitalists  and  would  make  the 
costs  arrived  at  less  significant  for  the  reason 
already  given  in  the  foregoing  pages. 

The  method  of  determining  the  basis  of  the  inter- 
est charge  and  the  percentage  of  interest  to  be 
allow^ed  is  as  little  understood  by  accountants  as  the 
theory  underlying  the  problem  of  interest.  It  has 
been  shown  that  capital  is  the  basis  of  interest  and 
not  the  valuation  of  capital  goods.  True,  tlie 
original  cost  of  the  capital  goods  is  used,  but  this 
original  cost  is  in  no  sense  their  proper  valuation 
at  any  time;  the  original  cost  is  used  because  it  rep- 
resents the  amount  of  capital  poured  into  the  busi- 
ness. Furthermore,  it  has  been  explained  that  no 
revaluations  are  allowable  but  that  all  profits  and 
interest,  due  the  stockholders  but  left  in  the  business, 
are  additions  to  capital.  Thus,  much  of  the  technic 
involved  in  computing  the  interest  charge  is  gener- 
ally understood,  although  the  theoretical  reasons 
given  by  accountants  for  the  use  of  original  cost  are 
never  satisfying.  About  the  interest  rate  to  be 
charged  there  is  even  less  cogent  reasoning.  Obvi- 
ously, the  interest  rate  to  be  charged  should  be  that 
prevailing  at  the  time  the  capital  was  invested. 
When  the  bondholder  invests  $1,000  at  five  per  cent, 
he  does  not  expect  to  receive  a  higher  rate  later,  even 


188   ECONOMICS  FOR  THE  ACCOUNTANT 

if  the  interest  rate  rises.  The  entrepreneur  who 
invests  his  capital  does  it  with  the  understanding 
that  he  has  a  long-time  investment  and  he  should 
calculate  interest  just  as  if  he  were  a  bondholder. 
If  he  reinvests  some  of  his  profits  or  interest  at  a 
later  period,  the  interest  allowed  on  them  should  be 
charged  at  the  percentage  prevailing  for  that  type 
of  investment  when  these  profits  and  interest  were 
earned  and  reinvested,  that  is,  not  withdrawn. 

The  method  outlined  for  determining  the  interest 
charge  may  seem  hard  to  apply  but  the  same  may  be 
said  of  the  proper  method  of  charging  depreciation. 
If  the  accountant  will  keep  an  accurate  record  of 
interest  paid  and  of  a  proper  interest  charge  for  the 
entrepreneur's  capital  when  invested,  there  will  be 
no  difficulty  except  with  the  reinvested  profits  and 
interest.  Something  concerning  the  method  of  treat- 
ing these  additions  to  capital  has  already  been  given 
in  Chapter  XL  For  the  use  of  firms  that  have  no 
way  of  determining  what  interest  rates  applied  in 
the  past,  the  accountants,  with  the  help  of  the  banks, 
should  attempt  to  compile  adequate  tables  for  dif- 
ferent geographical  sections  and  for  different  indus- 
tries. 

Some  accountants  find  a  certain  technical  difficulty 
in  charging  interest  into  cost,  but  this  difficulty 
arises  out  of  the  misconception  that  interest  is  the 
business  organization's  income  in  the  same  way  that 
economic  profit  is.  When  a  stockholder  receives  a 
salary,  this  salary  is  charged  to  cost  and  credited 
to  some  real  account,  usually  either  Cash  or  the 
stockholder's  personal  account.    The  same  procedure 


INTEREST  AS  A  PART  OF  COST  189 

can  be  followed  in  the  matter  of  interest.  A  real 
account  should  be  credited  and  cost  should  be 
charged  with  the  interest  on  the  stockholder's  invest- 
ment. The  feeling  that  interest  should  not  be 
credited  to  a  real  account  has  probably  been  caused 
by  the  belief  that  interest  is  income  in  the  sense  that 
profit  is  income,  but  this  credit  is  no  more  illogical 
in  the  case  of  interest  than  in  the  case  of  salary. 


APPENDIX  II 

CASH    DISCOUNTS    ON    SALES,    BAD    DEBTS,    OUTWARD    FREIGHT, 
DONATIONS,  AND  TAXES  ON  PROFITS 

There  are  certain  disputed  items  of  accounting 
cost  that  probably  should  not  be  discussed  in  an  eco- 
nomic treatise,  but  inasmuch  as  the  economic  prin- 
ciples announced  in  the  foregoing  pages  may  help  to 
clarify  their  treatment,  they  are  considered  in  this 
appendix. 

Discount  on  Sales 

When  a  corporation  sells  its  product,  it  desires  to 
receive  as  prompt  payment  as  possible,  and,  there- 
fore, often  offers  a  discount  of  two  or  three  per  cent 
on  sales  for  cash  or  prompt  payment.  It  is  a  much 
mooted  question  as  to  whether  such  cash  discounts 
should  be  deducted  from  the  Sales  or  added  to  Cost. 
Probably  the  accountant's  first  impulse  is  to  treat 
such  discounts  as  deductions  from  Sales.  If  a  desk 
is  sold  for  $100,  but  with  a  cash  discount  of  two  per 
cent,  the  buyer  who  pays  promptly  gets  the  desk  for 
$98.  The  seller  is  willing  to  take  a  price  of  $98  from 
the  cash  buyer,  just  as  he  might  make  a  lower  price 
for  any  other  type  of  preferred  customer.  Most 
accountants,  however,  do  not  classify  such  cash  dis- 
counts as  deductions  from  Sales  but  as  financial 
expense  for  the  reason  that  prompt  payment  enables 
them  to  borrow  less  capital.     The  discount,  there- 

190 


DISPUTED   ITEMS  OF  COST  191 

fore,  is  like  an  interest  pa^mient  to  the  customer  who 
furnishes  capital  by  paying  promptly.  It  may  seem 
that  it  makes  little  difference  how  such  an  item  is 
treated  because  the  two  methods  result  in  the  same 
profit.  However,  not  only  as  a  matter  of  theory,  but 
also  because  cost  should  be  defined  definitely  and 
consistently,  there  should  be  agreement  as  to  the 
proper  items  to  be  included.  If  a  buyer,  for  example, 
agrees  to  pay  cost  and  a  certain  margin  of  profit, 
cost  should  be  defined  in  unmistakable  terms. 
Furthermore,  when  an  accountant  says  cost,  it 
should  mean  something  definite  and  understandable. 
The  entrepreneur  has  two  types  of  business  trans- 
actions, those  with  customers  and  those  w^ith  the 
other  factors  of  production  or  other  entrepreneurs 
who  help  in  his  producing  unit.  Thus,  he  pays  wages, 
rents,  interest,  and  prices  for  raw  materials,  and 
he  receives  prices  for  his  finished  products.  It 
might  appear  that  the  discount  on  sales  is  not  a  pay- 
ment or  cost  in  the  sense  that  it  is  paid  to  the  factors 
of  production.  In  so  far  as  it  is  a  payment,  it  is 
paid  to  customers;  therefore,  it  might  seem  that  it 
should  not  be  considered  in  connection  with  cost  but 
merely  in  connection  with  sales.  There  is  an  obvious 
answer  to  this,  which  the  accountant  might  urge, 
namely,  that  the  customer  as  prompt  payer  is  not  a 
customer  but  capitalist,  and  he  receives  his  discount 
as  capitalist  and  not  as  customer.  Whether  a  cus- 
tomer who  pays  his  bills  promptly  should  be  thought 
of  as  doing  anything  so  unusual  as  to  be  called  financ- 
ing is  a  question,  but  there  is  probably  much  to  be 
said  for  it. 


192   ECONOMICS  FOR  THE  ACCOUNTANT 

The  second  question  to  be  considered  is  the  fact 
that,  if  the  discount  is  treated  as  a  deduction  from 
Sales,  the  price  line  of  the  price-cost  curve  may  be 
affected.  The  price  line  of  the  diagram  on  page 
143  was  shown  as  a  straight  line.  If  some  of  the 
buyers  took  their  cash  discounts  and  others  did  not, 
different  companies  might  realize  different  average 
prices.  In  that  event  the  price  line  would  not  be 
shown  as  a  straight  line,  if  the  discounts  were 
deducted  from  Sales.  However,  economic  theory 
makes  an  unwarranted  assumption  when  the  price 
line  is  represented  as  a  perfectly  straight  line.  Pro- 
ducers do  not  always  receive  the  same  prices  for  the 
same  commodity ;  they  may  sell  in  different  markets 
or  under  different  conditions.  Therefore,  there  could 
be  no  valid  objection  on  this  score  to  the  deduction 
of  discounts  from  Sales.  Finally,  if  the  assumptions 
of  theory  apply  there  is  no  reason  why  one  seller 
would  not  have  relatively  the  same  amount  of  dis- 
count to  pay  as  another. 

Probably  the  most  important  question  in  connec- 
tion with  this  problem  is  the  possibility  of  including 
a  charge  for  discount  in  cost.  In  constructing  a  unit 
cost  before  the  Sales  are  consummated,  there  would 
be  no  way  of  knowing  definitely  what  charge  to  allow 
for  discounts.  Some  customers  might  take  the  dis- 
count whereas  others  would  not.  Thus,  discounts 
are  analogous  to  taxes  on  profits,  which  cannot  be 
determined  until  Sales  are  consummated.  They  ai'e 
dependent  not  only  upon  the  size  of  the  Sales,  but 
also  upon  the  promptness  of  payment  after  the  Sales 
are  consummated.     This  last  consideration,  more 


DISPUTED   ITEMS  OF  COST  193 

than  any  other,  should  argue  for  the  exclusion  of  dis- 
counts from  cost  and  their  deduction  from  Sales/ 
The  use  of  cost  as  a  basis  of  price  is  only  one  of 
the  purposes  of  cost  accounting.  The  other  purposes, 
set  forth  in  the  early  chapters  of  this  book  and  in 
Appendix  I,  namely,  for  measuring  profit  on  dif- 
ferent lines  after  the  product  is  sold,  for  the  valua- 
tion of  inventories,  and  for  the  analysis  of  itemized 
costs  in  order  to  effect  economies  represent  uses  of 
cost  after  the  sales  are  consummated.  For  these 
purposes,  the  inclusion  of  Cash  Discounts  in  cost 
would  not  be  so  objectionable,  but  since  there  is  as 
much  to  be  said  for  their  deduction  from  Sales  as 
for  their  inclusion  in  cost  and  since  one  of  the  prin- 
cipal purposes,  if  not  the  principal  purpose,  of  cost 
accounting  is  the  determination  of  a  basis  for  future 
price,  it  seems  best  to  exclude  them  entirely  from 
accounting  cost.  In  this  connection  it  might  be  inter- 
esting to  note  that  some  accountants  have  argued 
against  the  inclusion  of  interest  in  cost  for  the  same 
reason  that  has  been  given  here,  namely,  that  the 
interest  is  not  determined  until  the  sale  is  made. 
This  confuses  interest  and  profit ;  interest  is  a  charge 
the  moment  capital  is  invested  and  is  not  affected 
by  sales.^ 

Bad  Debts 

Very  often  in  this  imperfect  world  customers 
obtain  goods  but  fail  to  pay  for  them.  Whether  the 
amount  of  such  Bad  Debts  should  be  deducted  from 


^  See  the  definition  of  accounting  cost,  page  82. 
'See  page  182. 


194   ECONOMICS  FOR  THE  ACCOUNTANT 

Sales,  included  in  cost,  or  treated  as  a  deduction 
from  realized  profit  is  another  one  of  the  disputed 
problems  of  accounting,  If  a  manufacturer  sells  100 
desks  at  a  price  of  $100,  and  receives  payment  for 
only  99  of  them,  he  has  sold  100  desks  but  has  real- 
ized only  $99  on  each  desk.  It  may  be  maintained, 
however,  that  he  really  sold  99  desks  at  an  average 
price  of  $100  and  that  he  practically  gave  away  or 
lost  one  desk.  If  in  manufacturing  the  desks  one 
had  been  ruined,  the  production  divisor  would  have 
been  99  instead  of  100  and  the  cost  would  have  been 
consequently  greater.  This  may  seem  to  argue  for 
the  inclusion  of  the  Bad  Debts  in  cost.  In  the  last 
analysis,  however,  the  same  reasoning  applies  here 
that  applied  in  the  case  of  Cash  Discoimts.  Bad 
Debts  cannot  be  included  in  cost  until  after,  and  in 
many  instances  until  long  after,  the  sales  are  con- 
summated. Therefore,  it  seems  desirable  to  deduct 
all  the  definitely  known  Bad  Debts  from  Gross  Sales 
in  arriving  at  Net  Sales,  and  to  deduct  the  doubtful 
accounts  from  profit. 

OuTWAED  Freight 

When  a  producer  sells  a  commodity,  he  can  sell  it 
f.  0.  b.  factory  or  delivered.  If  he  sells  it  f .  o.  b. 
factory,  the  buyer  pays  all  the  freight  charges 
between  the  factory  and  the  destination  required  by 
the  buyer.  If  the  seller  sells  it  delivered,  he  pays 
the  freight.  If  the  seller  pays  the  freight,  he  will 
probably  add  it  to  the  price  he  charges. 

In  order  to  simplify  the  problem,  it  can  be 
assumed,  at  first,  that  those  goods  sold  delivered 


DISPUTED   ITEMS  OF  COST  195 

have  the  actual  freight  paid  on  each  shipment  added 
to  the  price  and  that  the  goods  sold  f .  o.b.  factory 
include  no  freight.  Then,  if  Outward  Freight  is 
deducted  from  Gross  Sales,  the  Net  Sales  Avill  give 
the  prices  actually  paid  for  the  commodity.  However, 
the  accountant  may  contend  that  the  manufacturer 
is  receiving  different  prices  for  the  different  units  he 
is  producing,  and  that  these  different  prices  are 
prices  for  the  commodity  and  for  freight.  Thus,  the 
manufacturer  in  Pittsburgh  is  selling  steel  to  a  buyer 
in  Pittsburgh,  steel  and  the  freight  to  Baltimore  to 
a  buyer  in  Baltimore,  steel  and  the  freight  to  New 
York  to  a  buyer  in  New  York.  Obviously  if  the 
accountant  is  computing  a  unit  cost  as  the  basis  of 
selling  price,  he  would  have  to  have  a  different  cost 
for  the  buyers  in  each  city.  Furthermore,  in  comput- 
ing cost  before  the  sale  was  arranged,  he  would  be 
unable  to  determine  the  Outward  Freight  until  the 
destinations  of  the  different  units  were  determined. 
Thus,  it  seems  desirable  to  make  a  general  rule  of 
deducting  Outward  Freight,  as  well  as  Cash  Dis- 
counts and  definitely  known  Bad  Debts,  from  Gross 
Sales  in  order  to  arrive  at  Net  Sales.  In  that  event, 
the  price  line  ^  would  not  be  affected  by  the  different 
freights. 

Donations 

The  producer  is  often  called  upon  to  make  dona- 
tions to  charities,  to  the  Red  Cross,  or  to  similar 
organizations.  He  usually  considers  such  donations 
as  a  part  of  his  cost.    He  argues  that  they  are  neces- 

*  See  page  143. 


196   ECONOMICS  FOR  THE  ACCOUNTANT 

sary  for  the  establishment  of  the  goodwill  of  his 
business. 

If  Donations  are  included  in  cost,  the  consumers 
pay  them.  It  may  be  argued  that  consumers  pay  all 
the  elements  of  price  including  profit.  However,  it 
should  be  realized  that  if  Donations  are  included  in 
cost,  the  consumer  is  really  paying  them  for  the 
entrepreneur,  whose  profit  is  not  reduced  and  whose 
goodwill  is  established  without  any  sacrifice.  If  a 
donation  deserves  the  name,  it  should  be  given  by 
the  donor,  that  is,  the  entrepreneur,  and  it  should 
reduce  his  profit.  The  same  principle  applies  in  the 
matter  of  the  tax  on  profit.  The  Government 
definitely  says  that  it  will  take  a  part  of  the  entre- 
preneur's profit;  if  this  tax  could  legally  be  added 
to  cost,  it  would  be  paid  by  the  consumer,  not  by  the 
entrepreneur.  Both  taxes  on  profits  and  Donations 
represent  divisions  of  profit  and  not  items  of  account- 
ing cost.  Wlien  prices  are  demoralized,  however,  the 
inclusion  of  these  items  in  cost  would  not  necessarily 
shift  them  to  the  consumer;  in  such  times  they  would 
undoubtedly  reduce  profits  or  increase  losses.  How- 
ever, in  normal  times  or  in  times  of  high  prices,  the 
accounting  treatment  of  such  items  would  help  to 
determine  who  actually  paid  them. 

Tax  on  Profits 

There  is  an  interesting  question  as  to  whether  the 
accountant  should  include  the  tax  on  profits  in  cost. 
Obviously  the  bulk-line  producer  would  have  no  such 
tax  in  his  cost,  because  he  would  have  none  to  pay. 


DISPUTED   ITEMS  OF  COST  197 

Furthermore,  the  tax  conld  not  be  included  in  cost 
when  profit  is  being  determined,  because  its  inclu- 
sion would  presuppose  that  profit  was  already 
determined;  it  is  a  tax  based  on  profit.  However, 
after  it  is  determined,  that  is,  after  price  is  fixed,  it 
might  very  well  be  added  to  the  other  costs  or  mone- 
tary sacrifices  of  the  entrepreneur.  But  if  the  cost 
is  to  be  used  by  the  entrepreneur  merely  as  a  basis 
for  fixing  a  price,  it  should  not  include  the  profit 
tax.  Furthermore,  in  determining  cost  for  the  pur- 
pose of  computing  the  profit  tax  to  be  paid,  it  would 
be  absurd  and  logically  impossible  to  attempt  to 
include  such  a  tax  in  cost. 


APPENDIX  III 

QUESTIONS  IN  ECONOMICS  FOR  C.  P.  A.  EXAMINATIONS 

It  has  come  to  be  realized  that  the  accountant 
must  have  some  training  in  economics  as  a  part  of 
his  equipment.  In  some  States  questions  in  eco- 
nomic theory  and  applied  economics  are  given  in 
the  C.  P.  A.  examinations.  These  questions  are 
usually  framed  by  economists,  who  have  no  knowl- 
edge of  or  interest  in  the  kinds  of  questions  the 
accountant  should  be  expected  to  answer.  Some  of 
the  questions  asked,  moreover,  reflect  the  special 
interest  of  the  economist  who  framed  them.  It  would 
be  unreasonable  to  expect  the  accountant  to  acquire 
complete  information  in  all  the  fields  of  applied 
economics,  such  as  money  and  banking,  railroads, 
foreign  exchange,  etc.  Yet,  it  is  quite  as  unreason- 
able to  give  any  accountant  a  C.  P.  A.  certificate 
unless  he  grasps  the  fundamental  principles  of  eco- 
nomic theory,  on  which  the  philosophy  of  account- 
ing is  based. 

The  following  questions,  which  have  been  culled 
from  C.  P.  A.  examinations,  are  some  of  the  better 
ones. 

The  student  can  find  suggestions  for  answers  to  the  follow- 
ing questions  in  Chapter  III: 

Discuss  the  motives  in  economic  activity.     (Wis.,  Nov., 
1919.) 

198 


C.   p.   A.   QUESTIONS  199 

State  what  you  mean  by  consumption,  production,  and 
distribution.     (N.  D.,  June,  1914.) 

Distinguish  production  and  consumption.   (N.  D.,  1919.) 

Define  production,  iUustrating  the  several  ways  in  wliich 
it  can  be  affected. 

Define  economic  goods.  How  are  economic  goods  dif- 
ferent from  free  goods?     (Md.,  Dec,  1917.) 

Explain  what  is  meant  by  the  following:  good;  free 
good;  capital  goods;  consumer's  goods;  production 
goods.    (Wis.,  Nov.,  1919.) 

Name  and  describe  the  factors  of  production.  Differ- 
entiate between  fixed  and  circulating  capital.^  Give 
example.     (Wis.,  April,  1914.) 

Distinguish  fixed  and  circulating  capital.^  (N.  D.,  July, 
1919.) 

How  does  land  differ  from  capital  as  an  agency  of 
production?^     (N.  D.,  June,  1914.) 

Describe  the  process  by  which  capital  goods  come  into 
existence  and  are  made  available  for  productive 
use.     (Wis.,  April,  1918.) 

Name  and  describe  the  factors  of  production.  Classify 
the  following  under  the  respective  factors  of  which 
they  are  examples:  a  newsboy,  steam  locomotive, 
coal  deposits,  pig  iron,  bookkeeper,  State  Official, 
pile-driver,  draft  horse,  stock  of  shoes,  insurance 
salesman.    (Wis.,  April,  1918.) 

Are  money-making  and  production  identical?  Explain. 
(Wis.,  Nov.,  1919.) 

Define  capital.  Why  is  interest  paid  for  capital  ?  (Md., 
Dec,  1917.) 


*  Capital  is  probably  used  here  in  the  sense  of  capital  goods.     See 
also  Chapter  XI. 


200   ECONOMICS  FOR  THE  ACCOUNTANT 

The  student  can  find  suggestions  for  answers  to  tJie  follow- 
ing questions  in  Chapter  IV: 

On  what  basis  would  you  allocate  gross  income  to  rent, 
wages,  interest,  and  profits?  That  is,  what  is  each 
economically  entitled  to?     (Wis.,  Nov.,  1919.) 

What  fixes  the  market  rate  of  wages?  (N.  D.,  Aug., 
1917.) 

If  in  a  given  country  the  laborers  receive  one-third 
of  the  annual  income  of  the  country,  would  an 
increase  in  the  efficiency  of  the  laborers  increase 
the  proportion  received  by  the  laborers?  (Md., 
Dec,  1917.) 

What  is  pure  interest,  and  what  other  elements  enter 
into  actual  rates?  ^    (N.  D.,  Aug.,  1917.) 

What  effect  does  the  invention  of  machinery  have  on 
the  rate  of  interest?  ^    (Md.,  Dec,  1917.) 

What  is  interest  ?    Why  is  it  paid  ?    (N.  D.,  June,  1914. )  ^ 

Discuss  rent.     (N.  D.,  July,  1919.) 
The  student  can  find  suggestions  for  answers  to  the  follow- 
ing questions  in  Chapter  VI: 

What  do  you  understand  by  demand?  (N.  D.,  July, 
1919.) 

What  do  you  understand  by  the  law  of  diminishing 
utility?    (N.  D.,  July,  1919.) 

State  the  law  of  diminishing  utility  and  illustrate  by 
a  diagram  and   an  explanation  of  the   diagram. 
(Md.,  Dec,  1917.) 
The  student  can  find  suggestions  for  answers  to  the  follow- 
ing questions  in  Chapter  VII: 

Define  money.  What  is  the  difference  between  "stand- 
ard of  value"  and  ** medium  of  exchange"?  (Wis., 
April,  1918.) 

'  See  also  Chapter  XI  and  Chapter  XII. 


C.   p.   A.   QUESTIONS  201 

How  does  money  act  as  a  standard  of  value  and  what 
is  the  chief  requirement  of  the  substance  used  as 
such  standard?     (N.  D.,  Aug.,  1917.) 

What  fixes  the  value  of  money?     (N.  D.,  Aug.,  1917.) 

What  is  money?  What  is  a  standard  dollar?  (N.  D., 
June,  1914.) 

It  is  argued  that  the  United  States  should  not  burden 
future  generations  with  additional  Liberty  Bond 
issues,  but  should  adopt  the  simpler  and  cheaper 
expedient  of  issuing  and  using  paper  money  in 
sufficient  quantities  to  pay  for  the  war.  Would 
this  be  a  good  or  poor  policy?  Why?  (Wis., 
April,  1918.) 

The  student  can  find  suggestions  for  ansi.vers  to  tlie  follow- 
ing questions  in  Chapter  IX: 

Explain  what  is  meant  by  fixed  and  variable  expenses. 

(Wis.,  Nov.,  1919.) 
Show  the  relation  of  fixed  and  variable  expenses  to  unit 

cost  of  production.     (Wis.,  Nov.,  1919.) 

The  student  can  find  suggestions  for  answers  to  the  follow- 
ing questions  in  Chapter  XI: 

Explain  the  relation  between  production,  consumption, 
and  prices,  using  the  present-day  industrial  situa- 
tion in  illustration.     (Wis.,  Nov.,  1919.)^ 

Explain  how  the  price  of  a  commodity  is  fixed  under 
competitive  conditions.^     (Md.,  Dec,  1917.) 

What  are  some  of  the  principal  factors  entering  into 
price  determination?  ^     (N.  D.,  July,  1919.) 

Suppose  the  price  of  butter  to  be  40  cents  per  pound. 
Why  has  the  price  been  fixed  at  that  point,  and 
under  what  conditions  would  it  probably  remain 


•  See  also  Chapters  V,  VI,  and  VII. 


202   ECONOMICS  FOR  THE  ACCOUNTANT 

at  that  point  (assume  normal  conditions,  and  not 
war  times)  ?     (Wis.,  April,  1918.)* 

Define  profits.  Is  the  payment  on  a  bond  a  profit? 
(N.  D.,  June,  1914.) 

The  student  can  find  suggestions  for  answers  to  the  follow- 
ing questions  in  Chapter  XIII: 

"What  is  the  law  of  diminishing  returns  as  applied  to 
extractive  industries?     (N.  D.,  Aug.,  1917.) 

What  do  you  understand  By  monopoly?  (N.  D.,  July, 
1919.) 

Show  how  market  prices  are  established  in  a  free  com- 
petitive market.  Contrast  this  with  the  fixing  of 
monopoly  price.     (Wis.,  April,  1914.) 

Indicate  what  effect  the  enforcement  of  the  Sherman 
Anti-Trust  law  has  had.     (Wis.,  April,  1914.) 

State  the  nature  of  the  Trust  Problem  before  Congress 
and  the  country  at  the  present  time.  (Wis.,  April, 
1914.)       , 

The  student  can  find  suggestions  for  an  answer  to  the 
following  question  in  Chapter  XIV: 

Summarize  strength  and  weakness  of  income  tax.  (N. 
D.,  July,  1919.) 

*  See  also  Chapters  V,  VI,  and  VII. 


INDEX 


Accounting  cost,  81 

Advertising,  63 

American    Tobacco    Company, 

163 
Anti-trust  legislation,  162,  163 

Bad  debts,  193 

Balance    sheet,    8-12,    116-119, 

121-127,  131-135 
Banking,  52 

Bank  of  Amsterdam,  68 
Bank  notes,  68,  69. 
Bargaining  power,  37,  153 
Barter,  65 
Bastable,  C.  F.,  166 
Bills  payable,  130 
Bonds,  43, 117 
Bonus.  146 

Bulk-line  cost,  148, 172 
Bureau  of  Markets,  154 
By-products,  94,  95,  96,  97,  98, 

99,  100,  101,  102,  103 

Capital,  24-26,  28,  30,  31,  43, 
85, 106, 107, 109, 113-135 

Capital  goods,  23,  24,  27,  28,  31, 
37,  109,  119,  120,  121,  139 

Capitalists,  21,  30,  40,  42,  43, 
83, 137, 138 

Cash,  117 

Cash  discounts,  190-193 

Checks,  69 

Clark,  J.  B.,  36,  38 

Clayton  Act,  163 

Collective  bargaining,  154 


Combinations,  1G2, 163 
Commercial  geography,  52 
Common  stock,  27,  28,  131 
Comijetition,  39,  152-164 
Competitive  system,  36 
Co-products,  94,  95,  96,  97,  98, 

99, 100, 101, 102,  103 
Consumers,  4,  50,  64 
Consumption,  18,  19,  47 
Consumption  goods,  21,  25 
Control  of  corporation,  27,  28 
Corporations,  27 
Corporation  finance,  53 
Cost,  7,  8,  15-17,  20,  33,  51,  54, 

55,  56,  60,  61,  62,  63,  77-85, 

147,  160,  161 
Cost  of  living  theory  of  wages, 

39 
Cumulative  preferred  stock,  29 
Current  expenses,  96 

Demand,  49,  54-63, 144 

Depletion,  85,  90 

Deposits,  68 

Depreciation,   80,   85,   87,   110- 

112,  180 
Dewing,  A.  S.,  162 
Diminishing  returns,  159 
Discounts,  68 
Distribution,  31,  34-46,  48 
Division  of  labor,  22,  31 
Donations,  195,  196 

Economics,  3,  47-50 
Economic  goods,  20 


203 


204 


INDEX 


Economic  proportion  of  fac- 
tors, 16 

Entrepreneur,  4,  21,  26-31,  45, 
81,  113,  136-140, 177 

Entrepreneur's  cost,  81,  177 

Exchange,  32,  48 

Extensive  cultivation,  159,  160 

Factors  of  production,  21 

Factory  overhead,  87 

Federal  Trade  Commission,  155, 

156,  164 
Fixed  investment,  86 
Fluidity  of  labor,  capital,  and 

land,  153 
Foreign  exchange,  52 
Foreign  trade,  52 
Form  utilities,  19 
Free  goods,  20 
Free  trade,  4 

General  and  administrative  ex- 
pense, 87 
Gold,  66,  67,  68 
Good,  18 

Goodwill,  124-128,  131 
Gross  profit,  106, 150 

Huteheson,  Francis,  3 

Incidence  of  taxation,  169 
Income  and  excess  profits  tax, 

1,  170-173,  194,  196 
Increasing    returns,    158,    159, 

160,  161 
Industrial  management,  52,  53 
Inheritance  tax,  167 
Insurance,  52 
Intensive  cultivation,  159 
Intercompany  profit,  89 


Interdepartmental  profit,  89 

Interest,  12,  29,  32,  43,  69,  74, 
86,  105,  106-108,  112,  113, 
121,  122,  123,  124,  125,  128, 
129,  130, 148, 174, 177-189 

Interest  rate,  130 

Inventories,  117,  133,  134,  135, 
182 

Investment,  113,  127,  148 

Joint  costs,  94,  95,  96,  97,  98, 
99,  100,  101,  102 

Labor,  52,  53,  87 
Labor  organizations,  74 
Laborers,  4,  21,  48,  83 
Land,  22,  37,  86 
Landowners,  40 
Large-scale  production,  157 
Legal  tender,  26,  67 
Light,  Heat,  and  Power,  85 
Limited  liability,  27 
Luxuries,  58 

Maintenance  and  Repairs,  85 
Marginal  cost,  143 
Marginal  entrepreneur,  42 
Marginal  laborer,  38 
Marginal  land,  42 
Marginal  utility,  56-63,  64 
Marketing,  34,  35 
Materials  and  Supplies,  85 
Medium  of  exchange,  26,  66 
Minimum  of  subsistence,  40 
Money,  25,  26,  32,  64-71,  80 
Monopoly,  161,  162,  163 
Mortgage  bonds,  29 

Necessities,  57 
Notes  payable,  130 


INDEX 


205 


Outward  freight,  194, 195 
Overhead,  15,  16,  93 
Owners    of    land    and    capital 
goods,  21 

Paper  money,  67,  68,  69 
Partnership,  27 
Patent,  157 
Place  utilities,  19 
Political  economy,  3 
Preferred   stock,'  29,   130,  137, 

138 
Price,  7,  32,  50,  54-62,  63,  69, 

72,  136,  147 
Price  control,  155-157 
Price  indices,  71,  72 
Prime  costs,  157,  158 
Production,  18,  19-22,  47,  53, 

92 
Production  goods,  21,  23 
Productive  laborers,  20 
Productivity,  36-38,  49 
Productivity    profit,    143,    144, 

146 
Profit,  7,  32,  33,  37,  45,  74, 122, 

123,  124,  125,  136,  137,  138, 

140-147 
Profit  and  Loss  account,  5,  8, 

12-14. 
Profit  sharing,  39,  146 
Protection,  4 

Quantity  theory  of  money,  69, 

70 
Quesnay,  3 

Raw  Materials,  15,  75.  84,  86, 

87-91 
Raw-material  cost,  88,  93,  94, 

95,  96,  97,  98,  99,  100,  101, 

102,  110,  157,  158 


Receivables,  117 

Rent,  32,  37,  41-43,  86,  90,  105, 

108-110 
Revaluation,  132 
Risk,  44,  140,  141,  142 
Royalty,  37 

Sacrifice  cost,  77,  78,  79,  80, 178 
Salaries,  39,  112,  178,  180 
Sales,  5,  32 
Salesmanship,  62,  63. 
Secret  rebating,  164 
Selling  expense,  20,  87 
Service,  18 
Sherman  Anti-Trust  Law,  162, 

163 
Shifting  taxes,  169 
Short-term  notes,  127,  128,  130 
Single  tax,  167-169 
Sinking-fund  provisions,  29 
Specialization  of  function,  22 
Stabilization  of  prices,  75 
Standard   of   living   theory   of 

wages,  39,  40 
Standard  Oil  Company,  163 
Standard  of  value,  66 
Stewart.  Sir  James,  3 
Stocks,  117 
Stockholders,  125 
Stockholders'  salaries,  107 
Super-marginal  land,  43 
Supply,  51,  54,  55,  56,  60,  61, 

62,  63,  144 
Surplus,  117,  131 

Tariff,  169,  170 
Tax,  166,  167 
Taxation,  1 
Time  utilities,  19 
Total  utility,  59 


206 


INDEX 


Trade  associations,  155, 156 
Transportation,  52 

Unfair  competition,  161 
Unit  cost,  74, 181, 182 

Valuation,  12,  119,  120 
Value  in  exchange,  56 


Value  in  use,  56 
Voting  trust,  30 

Wages,  22,  32,  37,  38-41,  86,  91, 

158 
Walker,  Francis,  45 
Wealth  of  Nations,  3 
Withers,  Hartley,  69 


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